A Little Lesson About Prices

The other day we attended a baby shower. My wife sent me to the store to pick up a gift while she was getting ready. As is my custom when going to baby showers, I planned to buy diapers and baby wipes for the mother to be. One thing that I always forget to pick up is a fancy bag to put the present in. Being a man, it seems a little ridiculous to me to spend money on something that is purely decorative and will soon be thrown away. To be honest, I would just assume give the gift to the hosts in a grocery bag. But for the sake of domestic harmony, I make an effort to visit the gift aisle and get a pretty bag.

I knew going in that I wanted to spend $30. The $30 would be spent on the best possible combination of diapers, baby wipes, gift bags, and gift cards that I could cobble together. My real goal was to make the gift bag look as full as possible so that I would get credit for giving a big gift.

As luck would have it, everything that I wanted to buy was on the same aisle. Unfortunately, for whatever reason, everything was being repriced and there were literally no prices whatsoever on any items.

Can you believe it? It’s true.

On the one hand, I was a little ticked off. On the other hand, this was such a beautiful, practical example of the importance of prices to the economy. I had no idea what to buy.

My goal was clear. The resources available for achieving the goal were known. Yet, I had no way to rationally determine how to deploy those resources for the purpose of achieving my goal. I was unable to act. Any choice I made would have been purely arbitrary. Without prices to aid me in my calculations, I surely would have squandered my money.

There were a vast number of options for pretty bags. If I chose the most expensive one, I’d have less money for the other items. But, to be candid, the bag was the least important thing to me. Which one to choose?

I offer a second scenario. As an accountant I’m loathe to admit this, but recently I wrote a bunch of checks without recording them in the check register. The checks hadn’t cleared yet and I’d forgotten exactly how much they were for. That being the case, I was walking around not really sure about how much I had in my checking account.

This is the flip side of the first scenario. I knew the goals I wanted to accomplish with my money. I knew the amount of resources necessary to accomplish the goals. But I had no dollar value for the resources at my disposal. Again, I had a difficult time making decisions.

If I knew I had a lot of money, I would have gone for a spin on a merry-go-round, eaten cotton candy, and taken the misses out for a fancy lunch. Not knowing how much I had, I was forced to buy a frozen pizza and watch Seinfeld DVDs at the house.

Lack of money prices prohibited me from making the best use of my resources.

It is clear that we need money prices to rationally deploy the resources at our disposal. Without money prices, it becomes very difficult to make economic decisions.

Now, put yourself in the place of the pretty bag makers. They’ve got tons of decisions to make. Blue bags or red bags? Glitter or no glitter? What size? What material? Where to sell?

They too are guided by prices. The pretty bag company has a certain amount of money and capital equipment in its possession. If they’ve been in business for a while, they can look back at which bags have sold at what prices. They can use that information to guess at how much they can get for the same bags in the future. Given these prices, calculations can be made about the best way to spend their money and use their equipment. If paper and glitter for a certain bag cost X and the price they can get for the bag costs Y, they’ll be guided by trying to maximize Y-X for the bags they manufacture.

Rationality!

Now imagine that all prices for paper and glitter disappeared overnight. The company still knows the prices they are likely to fetch at the grocery store. Of course, their bank statement tells them how much money they have. However, without X in the equation Y-X they cannot make any sense of the situation.

Irrationality.

When a person, any person, goes to the grocery store they are willing to pay more for the items that they have a stronger desire for. For example, I’ll pay 25% more for organic lettuce than regular lettuce. It’s more valuable to me because I think its healthier (who knows if I’m right). If enough people feel the same way as I do, producing and selling organic lettuce will become more profitable than produing regular lettuce. The Y-X from above will favor the organic product. More organic will be brought to market.

In this way, prices indicate to the producers of stuff which items people want. Fantastically, it is also an amazing harmonizing mechanism. Business people’s quest for profit and personal gain is subordinated to the will of the consuming public.

When the government interferes with prices, it tends to bring about the opposite of its desired effects.

Say the government decides that everybody should be eating organic. In order to facilitate this policy, they ordain that organic produce must be sold at the same price as regular produce. This way everybody can afford to eat healthy, chemical free vegetables.

When a guy like me gets to the store and sees the prices, I’m going to load up. So will everybody else who buys organic. The new low prices will encourage everybody to buy more.

However, that damn Y-X equation from above, that is guiding production, doesn’t favor organic. The organic Y doesn’t have the 25% premium in it that it used to have. The amount produced will not increase because it isn’t as profitable as it used to be.

Shortages will ensue. The failure of the policy surfaces. Precisely the goods that the government was trying to make more available are now less available.

One last example. Imagine that the government decides that the organic industry isn’t making enough. They’re doing a fine thing for the country and they deserve to earn more. The government decrees that from now on organic is to sell at a 40% premium over regular produce.

Farmers take one look at their Y-X and see that organic is now highly profitable. They shift their production to meet what they think is increased demand.

I show up to the store and the produce section in packed to the rafters with organic vegetables. But what in the hell? A 40% premium! I want to be healthy, but I don’t want it that bad. I go for the regular lettuce. The farmers lose money and the vegetable rot on the shelves.

Specifically the group that the government wanted to aid, they’ve ended up harming.

To conclude, we’ve learned that in order to make rational use of resources, we need prices. Otherwise our decisions are arbitrary and wasteful. Prices are used by producers to shift their production towards the things that consumers want the most. They harmonize the profit motive with needs and wants of the public. Also, whenever the government messes around with the price structure, there are unforeseen consequences. Often, the results are the exact opposite of what the government was trying to achieve.

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One Response to A Little Lesson About Prices

  1. galudwig says:

    Fantastic article! More people really should take a moment to reflect on how important prices are and how they come to be. Prices matter and value is subjective, understanding of these two economic truths gives us so much more insight in how the world works, and this post goes a long way towards explaining the first!

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