How the Price System Works

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Chapter 9: How the Price System Works

Economist Milton Friedman called Hazlitt’s description of the price system “a true classic: timeless, correct, painlessly instructive.” When discussing prices, Hazlitt builds upon the analysis we’ve seen so far and shows exactly what the prices system is and why it is of paramount importance to rational economic thinking.

The core of economics is understanding how men and women attempt to satisfy their most urgent wants, needs or “ends” amongst the innumerable different “means” of achieving them. Our technologically advanced  and globally connected society does not change the simple premise that humans engage in purposeful action to achieve their goals. Economics studies the laws of human action and social cooperation that emerge in pursuit of these goals. The price system is the result of social cooperation and is indispensable for a modern monetary-based economy.

Economic study begins humbly with Robinson Crusoe stuck on his desert island. “His wants at first seem endless. He is soaked with rain; he shivers from cold; he suffers from hunger and thirst. He needs everything: drinking water, food, a roof over his head, protection from animals, a fire, a soft place to lie down.” In short, he must choose between competing alternative “ends” while considering the best “means” of achieving them. Should Crusoe start by drinking water? Should he build a crude shelter, attend to some other needs, and then improve the shelter later? Or should he build a very solid shelter now and work inside this well-built shelter to satisfy other ends? Should he collect berries or attempt to fish? If he chooses to fish he must also gather materials to make a hook. There are an almost infinite amount of “ends” Crusoe could choose to satisfy; an equal number of alternative “means” that could achieve this job. Constrained by both time and labor productivity, Crusoe must judge between the vast alternatives available and make trade-offs regarding short-term and long-term goals.

“Elementary illustrations like this are sometimes ridiculed as “Crusoe economics.” Unfortunately, they are ridiculed most by those who most need them who fail to understand the particular principle illustrated even in this simple form, or who lose track of the principle completely when they come to examine the bewildering complications of a great modern economic society.”

Extending this lesson to society at large, Hazlitt asks a prescient question: “How is the problem of alternative applications of labor and capital, to meet thousands of different needs and wants of different urgencies, solved [for all of society]?” The answer is the price system.

Most people are aware that the interplay between supply and demand forces establish market prices, but if pressed for further details, their analysis will usually end there. Hazlitt points out that “prices are fixed through the relationship of supply and demand and in turn affect supply and demand.” The second part of this description is usually omitted altogether, so we’ll elaborate on this important point.

Image a news report that informs the world that broccoli successfully prevents cancer in 100% of patients who consume at least one cup of broccoli every day for the rest of their lives. In the short term, the supply of broccoli will remain the same while the demand for broccoli will shoot through the roof. As most people understand, this will make the price of broccoli rise dramatically to balance the new higher demand with the same supply as before.

Meanwhile, the price of producing broccoli remains largely unchanged. Since broccoli is fetching an abnormally high price on the market, in the short term broccoli producers are earning humongous profit margins. These massive new profits will attract capital and labor into broccoli production. As a result, more and more broccoli is produced (increased supply) and the price of broccoli will begin to fall until profit margins reach a level more in line with the economy at large.

In other words, prices convey information to consumers and producers. High prices with large profit margins attract producers while low prices and small profit margins repel new producers. Consumers also react to the price system by conservation of certain products in the face of high prices or increased consumption of a given good when prices are lower.

Ultimately, prices are determined by the value judgements of consumers who prefer one good over another, but the prices themselves reveal information about these preferences and help get consumers what they want as efficiently as possible.

The price system, arrived at by the actions of consumers and producers through free trade, is essential to the healthy functioning of a market economy. Economist Thomas Sowell sums it up well by saying “while capitalism has a visible cost – profit – that does not exist under socialism, socialism has an invisible cost – inefficiency – that gets weeded out by losses and bankruptcy under capitalism.  The fact that most goods are more widely affordable in a capitalist economy implies that profit is less costly than inefficiency.  Put differently, profit is a price paid for efficiency.”

Robinson Crusoe cannot afford to be inefficient while he attempts to remove himself from poverty. The same point holds true for society at large: If we want to eliminate poverty, we cannot tolerate inefficient use of resources.