Economics 101

How Prices Harness Knowledge

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Previously we have talked about how knowledge is held in a world of scarcity.  Knowledge is personally held and individually known, meaning that while people know different things, no one knows everything.  Nobel laureate, Friedrich August von Hayek called this the “knowledge of time and place.”  It raises questions over resourcefulness—how do we get anything done at all?

Hayek’s insight was so profound because it revealed that market exchange was able to harness dispersed knowledge with extreme efficiency and that this was done through prices.  Prices send important signals without requiring the buyer or seller to deeply understand all the intricacies behind each price.  In this way they serve to coordinate the behavior of large groups of individuals who don’t have the capacity to know all they would need to know otherwise.

Have you ever seen the game show, “The Price is Right?”  It is one of the longest-running television shows ever, and I suspect it is because there is something deeply fascinating about prices.  I remember liking this show growing up and thinking that if I did the grocery shopping in my house I would perform much better than the people on the show.  How can they be so wrong about the prices of items they purchase on a regular basis?  How do they not know exactly the price of toothpaste?

Let’s take a minute to think about toothpaste.  We all use it and buy it multiple times each year.  But what goes in to the price of each tube?  I honestly have very little idea.  I don’t even know the ingredients of toothpaste, besides fluoride, and the mysterious minty taste.  But I suspect there is a complex process that is involved in its production.   Ingredients are mixed together and put into a tube with a label.  All of that happens separately: the production of the actual toothpaste, the tube and the plastic wrapper. They all require separate and specific skill sets and production processes.

The beauty of prices is that they harness all of the activity that goes into the production of a product. As a consumer, I don’t need to know anything about how a product is made. All I really need to know is the price.  It sends important signals to me about how much I want one brand of toothpaste over another.  I can measure the price against what I would be willing to pay for the toothpaste and then decide what to do.

Prices are powerful at economizing on the information I need to make a decision.  If prices increase dramatically, I will most likely adjust my behavior.  In this example, if fluoride production becomes more costly and toothpaste prices increase, I may decide to buy less toothpaste or may try to waste less so I can purchase less.  But the price increase does not require that I understand the market for fluoride production.  It serves as a signal that gives me a new choice set, and I can decide when to alter my behavior based on the change in price.  Economist Thomas Sowell, in his book Basic Economics, writes,

Prices in a market economy are not simple numbers plucked out of the air.  While you may put whatever price you wish on the good or services that you provide, those prices will become economic realities only if others are willing to pay them—and that depends not on whatever prices you have chosen but on what prices other producers charge for the same goods and services, and what prices the customers are willing to pay. (Page 19)

But what about the producers of goods and services? Sellers are consumers too. Prices do the same things for them that they do for consumers.  A rise in fluoride prices will cause toothpaste producers to change their behavior, like searching out feasible fluoride substitutes. In a highly specialized economy it takes the complex interaction of many people to produce any given item.

An awareness of how prices work has implications for how societies are run.  We need an economic system that allows prices to do the heavy-lifting of harnessing knowledge because we are not capable of knowing everything ourselves.  Prices require that we depend on one another.

Finally, prices which are expressed in terms of currency should not be viewed with disdain; rather, they require a nuanced understanding.  If we understand prices in terms of the role they play in helping people make decisions amidst the vastness of the knowledge problem, we can instead embrace them as a gift.

Question: Notice today how prices affect your choices. How has this understanding of market exchange affected your perspective? Leave a comment here.

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