Wednesday, October 26, 2011

Price Theory

A few years ago, I had the privilege to listen Deirdre McCloskey give a talk when I was doing a post-doc at George Mason University. She told us that price theory was one of the most difficult theory of economics to understand. I agree. I have been teaching it for many years now and it's really painful to explain what prices come from, their role, and how important they are.

Carl Menger wrote Principles of Economics (1871) [original title is Grunds├Ątze der Volkswirtschaftslehre] and the entire book is dedicated to explain what the value of goods and services come from and to what extent values and prices are different.

Mises in "Economic Calculation in the Socialist Commonwealth" (1920) explains why a system devoid of property rights in the means of production cannot work efficiently as there are no prices and therefore no ability to calculate profits and losses to know where to allocate means of production, what to produce, in how many quantities.

Later, Hayek in "the Use of Knowledge in Society" (1945) explains the crucial role that prices play in saving people information and search costs to make effective decision because prices crystallize the local knowledge that market participants use when they make their decisions that create price movements.

Understanding the market process and the role of prices in allocating scarce resources to their most valued uses is crucial. But as important is the understanding how any meddling with the market process and the price system can lead to dramatic consequences. To be effective in allocating scarce resources to their most valued uses, the price system must work as freely as possible. As soon as the price system is hindered whether with price controls, taxes, subsidies, tariffs, quotas, or inflation, it can no longer perform its primary function of allocating resources to their most valued sources. Often the primary outcome of such interventions is "malinvestment," a term used by Friedrich Hayek to illustrate the process of investing resources in lines of production that are not profitable.

It is true that sometimes when unhampered the prices can lead to overinvestment, underinvestment, overproduction, underproduction, over consumption, or underconsumption particularly the property rights are not well-defined resulting in tragedy of the commons or pollution levels that above the efficient level, or the underconsumption of goods with positive externalities. But one cannot ignore the products of these imperfections of the real world that can be minimized either by market mechanisms or government intervention.

I encourage every student to think of the world in terms of prices. What price am I willing to pay to get what I think I need to get? What am I willing to sacrifice to get what I want or what I think we should have? Why some prices are so high? Why housing prices are so low? Does a high price necessarily mean that a good or service is extremely valuable and very rare? Does the very low price make the good less valuable or abundant?

Mises used to say that Central Planning was actually planned chaos. In a world without prices, the world would look like chaos. It would be one of misery, famine, poverty, and death.

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