Chapter 2 - The Role of Prices 

How does an economy allocate scarce resources?

Different kinds of economies do this differently.

• In a feudal economy, the lord of the manor simply tells the people under him what to do and where he wanted resources put.
• In a market economy coordinated by prices, there is no one at the top to issue orders to control or coordinate activities throughout the economy.

Economic Decision Making:

• Each ==consumer==, ==producer==, ==retailer==, landlord, or worker makes individual transactions with other individuals on whatever terms they can mutually agree on.
• If someone else somewhere else has a better product or a lower price for the same product or service, that fact gets conveyed and acted upon through prices, without any elected official or planning commission having to issue orders to consumers or producers indeed, faster than any planners could assemble the information on which to base their orders.
• Given that any modern economy has millions of products, it is too much to expect the leaders of any country to even know what all those products are.
• Prices play a crucial role in determining how much of each resource gets used where and how the resulting products get transferred to millions of people.
• In countries where prices coordinate economic activities automatically, that lack of knowledge of economics does not matter nearly as much as in countries where political leaders try to direct and coordinate economic activities.
• Many people see prices as simply ==obstacles== to their getting the things they want.
• Price changes would enable a whole society indeed, consumers around the world to adjust automatically to a greater abundance of known products, even if 99 percent of those consumers were wholly unaware of the new discovery.
• The primary ==role of prices== is to provide ==financial incentives== to affect behavior in the use of resources and their resulting products.
• A free market economic system is sometimes called a ==profit system==, it is in reality a profit-and-loss system and the losses are equally important for the efficiency of the economy.
  • Losses force producers to stop producing what consumers don't want.
• Prices connect you with anyone, anywhere in this world, where markets are allowed to operate freely, so that places with the lowest prices for particular goods can sell those goods around the world.
• Price-coordinated markets enable people to signal to other people how much they want and how much they are willing to offer for it.
• Prices responding to supply and demand cause natural resources to move from places where they are abundant.
• When more of some item is supplied than demanded, competition among sellers trying to get rid of the excess will force the price down.
• The significance of free market prices in the allocation of resources can be seen more clearly by looking at situations where prices are not allowed to perform this function.
• In a market economy, the prices of ==surplus goods== would fall automatically by supply and demand, while the prices of goods in short supply would rise automatically.

Prices and Costs:

• Prices in a market economy are not simply numbers plucked out of the air or arbitrarily set by sellers.
• Lower prices meant less greed, rather than changed circumstances that reduce the sellers’ ability to charge the same prices as before and still make sales.
• ==Competition== in the market is what limits how much anyone can charge and still make sales, so what is at issue is not anyone’s disposition.

Resource Allocation by Prices:

• We now need to look more closely at the process by which prices allocate scarce resources that have alternative uses.

• The situation where the consumers want product A and don’t want product B is the simplest example

  of how prices lead to efficiency in the use of scarce resources.

• But prices are equally important in more common and more complex situations, where consumers want both A and B, as well as many other things, some of which require the same ingredients in their production.

• What this all means as a general principle is that the price which one producer is willing to pay for any given ingredient becomes the price that other producers are forced to pay for that same ingredient.

Incremental Substitution:

• Since scarce resources have alternative uses, the value placed on one of these uses by one individual or company sets the cost that has to be paid by the others who want to bid some of these resources away for their own use.
• The resources tend to flow to their most valued uses when there is price competition in the marketplace.
• On the contrary, adjustments are incremental.
• Prices coordinate the use of resources, so that only that amount is used for one thing which is equal in value to what it is worth to others in other uses.

Economic Systems:

• What history can't tell you why a certain ==economic fluctuation== occured, economics helps explain why they happened.
• A rationally planned economy sounds more plausible than an economy coordinated only by prices linking millions of separate decisions by individuals and organizations.
• Knowledge is one of the most scarce of all resources, and a pricing system economizes on its use by forcing those with the most knowledge of their own particular situation.

Supply and Demand:

• There is perhaps no more basic or more obvious principle of economics than the fact that people tend to buy more at a lower price and less at a higher price.
• Demand versus “Need”:
  • When people try to quantify a country's need for this or that product or service, they are ignoring the fact that there is no fixed or objective need. Seldom, if ever, is there a fixed quantity demanded.
  • Likewise, there is no ==fixed supply.==
• “Real" Value:
  • The producer whose product turns out to have the combination of features that are closest to what the consumers really want may be no wiser than his competitors, yet he can grow rich.
  • The fact that prices fluctuate over time, and occasionally have a sharp rise or a steep drop, misleads some people into concluding that prices are deviating from their “real" values.
• Competition:
  • Competition is a crucial factor in explaining why prices usually cannot be maintained at arbitrarily set levels.
  • It is the key to the operation of a ==price-coordinated economy.==
  • Prices don't remain the same over time, but follow some ideal pattern of allocation of resource remains the same indefinitely.
• Prices and Supplies:
  • Prices not only ration existing supplies, they also act as powerful ==incentives== to cause supplies to rise or fall in response to changing demand.
  • The gains and losses are not isolated or independent events.
  • The crucial role of prices is in tying together a vast network of economic activities among people too widely scattered to know each other.

Unmet Needs:

• One of the most common and certainly one of the most profound misconceptions of economics involves unmet needs.
• If economics is the study of the use of scarce resources which have alternative uses, then it follows that there will always be unmet needs.
• We may differ among ourselves as to what is worth sacrificing in order to have more of something else.
• Nothing is a need categorically, regardless of how urgent it may be to have particular amounts at particular times and places.
• Economics is about ==incremental trade offs==, not about needs or solutions.

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