What Is a Price, and What Is Its Purpose?

Perhaps no concept of economics is more misunderstood, to greater human detriment, than that of price. This misunderstanding can be traced back centuries, to laws against usury and the concept of a fair price, and has led to wrongheaded policies wherein lawmakers, seemingly under the delusion that prices can be adjusted without consequence, have instituted all manner of government distortions on an essential market phenomenon. Just as a doctor does great work in proportion to the lethality of the disease which he cures, so too does the economist do greater work when the ignorance which he alleviates is responsible for graver social ills. If the good reader is willing, the humble blogger will expound on the concept of price, investigating its nature and significance and if the good reader will endure with but a modicum of patience, we may proceed, with the greater understanding obtained, to proffer some real world policy prescriptions and analyze and debunk faulty ones.

A price is nothing more and nothing less than an exchange rate. Once a general medium of exchange has been established in an economy, an interested party may, instead of exchanging ten eggs for a gallon of milk, exchange anything he likes in terms of money. A dozen eggs, therefore, may exchange for, say, two dollars. We may say that the exchange rate of eggs with respect to dollars is twelve for two, or, more simply, the price of a dozen eggs is two dollars.

The good reader will notice that some things have a price, while others do not, and may be curious as to why. Air is free under normal conditions, but apples must be purchased, i.e., they must be exchanged for. The reason for the difference is the scarcity of the things in question. In economics, something is said to be scarce when there is more demand for it than supplies can satisfy (the good reader will note that scarce does not mean rare, merely that supply is not sufficient to fully satisfy demand). Air, on the contrary, is superabundant and therefore carries no price.

If a good like an apple is scarce, then it is unavoidable that, after humans have taken possession of them according to their nature, at least one person will be left with either no apples or fewer apples than he would like to consume. At this point, unless, by miraculous coincidence, the apples have wound up in people’s possession according to a precise pattern of ownership, exchanges will take place. This will happen whenever an apple-less individual who has something he is willing to give up for a certain amount of apples finds an appled individual who wants that something more than that same or a greater amount of apples. In concrete terms, if Jaime has five apples and Mohamed has none, but Mohamed has a Pepsi which he is willing to exchange for two apples, and Jaime is willing to give up as many as three apples for the Pepsi, then if and when these two find each other an exchange will be made as soon as the knowledge of the other’s want is discovered. The exchange rate will be between two apples for the Pepsi and three apples for the Pepsi, which is the area where their desires to exchange overlap.

It is a natural thing for humans to exchange something they want less for something they want more, and when there is a general medium of exchange these exchange rates are called prices. Instead of apples and Pepsi exchanging for each other, they exchange for dollars or pounds or yen or euros or what-have-you. Not every exchange need take place through the general medium of exchange, but in practice nearly all of them do. One great advantage to this is that it allows actors in the market to calculate based on the exchange rate in dollars. Instead of tracking exchanges between cows and sweaters, then between sweaters and shoes, then between shoes and milk and finally milk and eggs to find the likely exchange rate between cows and eggs, all these products can be measured against money and calculation can be made easier.

It is a simple enough matter, in principle, to determine what the price level of a certain good will be, even if the complexities and flux of a real economy make it more confusing in practice. Let us imagine that a vendor has five apples, and that ten people desire to buy an apple. The first person is willing to pay one dollar for the apple, the second two dollars, the third three dollars and the rest follow in that pattern. The vendor does not know who wants the apples nor how much each is willing to pay, so he must begin a guessing game and hope he can attract a buyer (much of the job of an entrepreneur involves anticipating demand and the changing flow of people’s desires on the market). In this situation, any price at five dollars or less, assuming that word of the apple sale gets out to all interested parties, will clear the market of apples, i.e., all apples will be sold. Anything above five dollars will leave a glut of apples on the market which can only be solved by lowering the price. With repeated sales, the vendor will, dependant upon his ability as an entrepreneur, come to an understanding of what the true price should be.

For the next batch of apples, the apple vendor will look at the costs of his enterprise and decide how many apples to produce, which in the particular industry in question principally means deciding how many trees to plant. We shall keep the matter simple and ignore economies of scale, which mean a lower unit cost of production for each apple if more are produced, as well as the effect of inputs like fertilizer and variables like weather, none of which alter the essence of the example. We shall assume that, after everything is factored in, an apple can be produced for $3.50 per unit no matter the quantity produced. If our vendor decides to produce just one apple, he may sell it for $10.00, to the one who was willing to pay that much for an apple, and make a profit of $6.50. If he produces two he may sell them, assuming he cannot price discriminate, for $9.00 and make $11.00. If he produces seven apples, he can sell them for $4.00 and make $3.50. The vendor will make the most profit by producing four apples, selling them for $7.00 each and getting a profit of $14.00, a fact which he will arrive at according to his ability as an entrepreneur.

But this is not the whole story, because there is a profit opportunity to be made by anyone who can also produce apples at $3.50 per unit. If a competitor is free to enter the field, then he will try to undercut the first vendor and sell the apples for less. With competition the price of the apples will be driven downwards towards the $4.00 level, and from that point the vendor with the most success will be the one who figures out how to cut costs without cutting quality. It is true that they may collude to cut back production and keep their prices high, but this opens up the same profit opportunity that brought the first competitor into the field, and for this reason these collusion agreements, these cartels, are unstable and short lasting in a free market. Without exception, businesses which wish to reduce production to keep prices high, and have managed to do so for any lengthy period of time, have appealed to government to help them do it.

The good reader is now on familiar terms with the concept of price. On the market, without the need of a central planner to worry about rationing, free entry competition and profit maximization make for a price which rations for the market, emerging out of the decentralized actions of the various actors. When demand goes up, prices go up to make sure that the market clears, which means that everyone who wants an apple at a certain price can get it. It also increases profit margins, which attract more investment into an industry and cause it to expand, thus keeping the price from going too high and bringing more supply to compensate for the increased demand. When demand drops, the reverse happens and investment flows out of the industry and supply shrinks so that resources may be diverted to other, more urgently desired goods and services whose urgent desires, or demands, have caused their prices to go higher.

We can see, then, that the price arises not out of the whims of entrepreneurs but rather out of the interactions of free individuals on the market, of which group entrepreneurs form only a small part. If the price of something suddenly increases, it no more means that capitalists have suddenly become greedy than a sudden drop in price means that they have become generous. They are always trying to make as much profit as possible – just as the customers are trying to get their products as cheaply as possible – so if we observe a sudden change in price, we can with confidence declare that the forces of supply and demand have altered and this change is responsible for the change in prices.

With a good understanding of what a price is and what it does, the good reader is now equipped to see the flaw in thinking behind price controls. No more thoroughly debunked folly has ever passed through the bowels of a parliament, and yet it persists in policy, no matter that it failed for the ancient Egyptians as well as any and all governments since. Let us say that a parliament decides that $4.00 is too high a price to pay for apples and decides that no apple shall sell for more than $2.00 per unit. We can immediately see that nine of our ten prospective buyers will wish to purchase an apple and yet there are only seven apples to be bought. It was this very dynamic which determined the $4.00 price and the supply of seven apples. We might ask by what wisdom a politician has decided what the correct price is, but to what end? The price is now $2.00 per apple and we have waiting lines for apples.

When the current stock of apples very quickly runs out we will see a second effect come into play. Not only is demand over stimulated with respect to supply, supply is now under stimulated with respect to demand. Investment will be diverted from apple growing to other endeavors, so that fewer apples will be available the next time around, exacerbating the problem of growing waiting lines for apple eaters.

At this point a number of things happen. It is very apparent that no apple vendors can make a profit with the current allowed prices and production structure. Some will leave the field, and this may alleviate the price of the factors of production because of the reduced demand for them. However, if these factors, fertilizer, for instance, are not specific to apple growing then the demand for them from other industries will keep the price high. If the factors are specific to apple growing then they will drop in price, as the apple industry’s demand was the only demand input in the price, thus reducing the unit cost of production. If this cost per unit is not reduced to below $2.00 per unit, other actions will be taken. For instance, less fertilizer will be used, less soil preparation, less watering, i.e., fewer inputs, which means that the quality of apples will diminish. It is also possible that the apple vendors will go to their politicians and demand price controls on the factors of production. If these are granted then the problems the humble blogger has been at pains to detail are extended to other sectors of the economy. Once the factors of production, like fertilizer, are placed under price controls then the producers of these factors will take the same steps, decreasing the quality of these factors, and may also turn to government to put price controls on the factors of the factors of production. It is not hard to see, in theory, how a single price control could, by degrees, infect an entire economy, and take it from a free market to a centrally planned economy.

But notice that nothing has really been solved. Instead of four dollar apples, we have two dollar apples on those rare occasions when any are in stock, many of the people who were willing to pay $4.00 cannot get any apples at all, the quality of the apples has been reduced and, to top it off, price controls might be awaiting other industries in a vain attempt to solve the problems created by the original price control. It would behoove the citizens of any nation to understand price and to resist attempts to fix it according to arbitrary ideas. A price arises from market conditions, as we have seen, and no amount of passion can give us the power to wish a different price – a different market clearing price, that is – for something. Price is a symptom, an effect, of underlying conditions. A price control no more solves a supply shortage or an increase in demand, which led to a higher price, than peach colored skin dye cures jaundice in Caucasians. The sooner this is learned by the citizens of this planet, the sooner we can be rid of this particular bit of government nuisance.