You’re about to read what could be the most important post on my blog.
It’s going to explain one of the most fundamental concepts in economics.
Once you understand this concept and its implications, it will change the way you think about the world.
It’s called the price mechanism.
As informed citizens, we need the ability to analyse the costs and prices of products and services to make sure our money is well spent.
It’s also useful to be able to forecast the potential impact of external events on your household budget and finances so you can plan for your future.
And as an investor, understanding why financial markets move is key to success.
An understanding of the price mechanism can help you do all this.
What’s the price mechanism?
The price mechanism is the means by which the decisions of consumers and businesses interact to determine the allocation of resources. It’s a system where forces of supply and demand determine the prices of goods and services.
For example, in complex market economies such as the UK and the US, food is not allocated to families by central government control. It’s coordinated by the use of prices.
Food sellers are attracted to these economies by the prices on offer in the market.
But, it doesn’t happen randomly.
Everyone involved in the process makes an individual transaction with another on whatever terms are agreed on. The price reflects that agreement.
If there’s a better offer of a different product or cheaper price elsewhere, this information gets around pretty quickly, and customers go elsewhere.
It’s a far more efficient system of distribution than a central bureaucracy.
Which, with the best will in the world, cannot even begin to fathom what all the products are on sale globally, let alone how many resources should be allocated to producing them, when and where.
And, that’s because this problem is mind-blowing in scale.
But using prices means it’s much easier to determine which resource gets used, and where and how much should be allocated to the production of a product.
This is the function of the price mechanism.
It assists with economic decision-making.
But, prices have many other functions too.
What are the functions of price?
1. Transmission – prices transfer information
Prices convey news, like messengers.
Sometimes, the news is bad.
For example, in certain areas of the US and UK, there is a large demand for housing. However, there are not enough houses available to meet it. Since there’s a lot of competition for each house, the prices are pushed up, resulting in high house prices in these areas.
However, sometimes the news is good.
It may be that a new rare earth metal mine has been found, or a more efficient mining process discovered. It’s a niche area, and not likely many people will be aware of it.
However, everyone will notice their electronics becoming cheaper as the input price of the metal will drop.
The end result of the discovery – the information that matters for our personal decision-making – is highlighted to all.
Prices allow us to adjust to unknown events effectively.
2. Provision of incentive
One of the major roles of prices is to provide financial incentives that affect people’s behaviour.
But prices don’t only incentivise customers, they incentivise suppliers too.
For example, firms like electronics giant Apple don’t know exactly what their customers want. They only know that when it produces a product with one mix of features, it makes a profit but another product, with a different combination of features, won’t sell as well.
To sell unsold goods, Apple must drop the price or risk a bigger loss by not selling them at all.
These losses also tell producers what to stop doing because they are a signal that people don’t want it, whatever it is! And making things we don’t want is a waste of resources.
There’s no way that companies instinctively understand what millions of different people want. Prices provide the incentive to produce specific products.
Prices and supplies
So, prices cause supplies to rise and fall with changes in customer demand.
At the beginning of the pandemic, in many shops near me, prices for hand gel sanitisers went through the roof. Government advice to frequently sanitise your hands created a huge increase in demand for the gels.
Manufacturers then scrambled to be the first in the area to capitalise on the higher prices that resulted. It didn’t take too long for more supplies to arrive and the prices to drop down again through competition.
Similar things happened with the toilet roll.
This meant, that for us shoppers, we had goods rushed to us far more quickly than would otherwise have been the case.
The desire to earn money is a powerful incentive for action.
In comparison, where famine exists, it’s not uncommon for food supplied by aid agencies to spoil.
Greed may not be attractive. But, it can save lives.
3. Signalling: a core function of the price mechanism
Prices connect us all together anywhere in the world, provided there’s a free market.
This means you can own a phone made in China, jeans from the US and a shirt from Italy.
They allow us to let others know how much we want and what we’ll pay.
On the other hand, prices also allow us to show what we’re willing to supply and in exchange for what. Shortages are reflected in high prices, and surpluses are reflected in lower prices.
This same principle works for anything from raw materials to financial securities.
The changes in supply and demand of goods cause prices to respond and resources to move from places where they are in abundance to places where those same goods are scarce.
Indeed, prices are the only reason countries such as China can feed themselves. China is just under 20% of the world’s population but only about 10% of the arable land. In times past, recurring famines were huge problems. Now, prices attract food into China from other countries – it’s a huge market for many companies.
And China will pay for the goods it needs.
Prices are the bridge between supply and demand.
Sometimes situations arise when more of an item is supplied than is in demand. Sellers want to get rid of the excess, so prices are forced down, which limits any future production of the item.
The resources you’d then use to produce these goods can be used to produce something else.
On the other hand, when there is more demand than supply, there is competition amongst customers for the goods, so prices rise, incentivising using resources for further production.
Prices facilitate the matching of demand and supply, clearing the market. And in financial markets, once you know why there’s a high or lower demand for something, you can make better investing decisions.
5. Distributive (Distribution and rationing)
Prices also help with the distribution of goods and services.
However, the high prices of property in London are not the real reason we all can’t buy property there.
Sometimes, I think it’d be really useful to have a flat in the centre of London. (But, unfortunately for me, I can’t afford it, so I dump the very idea!)
The real reason we can’t all have properties there is there aren’t enough properties to allow everyone who wants one to have one. Property is limited due to space constraints.
But that doesn’t stop me from wanting one! And it doesn’t stop others from wanting one, either. So, the desire for a property in London is unlimited.
And therein lies the problem.
This means that lots of people effectively bid for only a few properties, and the highest bid wins. The high price reflects this reality.
This situation doesn’t change with a different owner or with a government decree that everyone should have property in London. There would still have to be a method of distribution (that often leads to nepotism).
6. The price mechanism allocates resources
How is it used to allocate resources?
The short answer is it tells producers what, when and for whom to produce. And it’s not arbitrary. Sellers can only sell when the price is agreed upon by a buyer.
Imagine yourself as a customer – like me – who likes to buy those yummy products made from flour – cakes, crackers and pastries.
In choosing to purchase each of these items, you are, in effect, bidding for the flour that produces them. The money generated by the sales of these items enables manufacturers to buy flour to continue to make their cakes, crackers and pastries.
However, if the demand for flour increases because people like cakes, cake makers use additional funds to bid away some of the flour that previously went into making crackers or pastries, to allow themselves to make more cakes. When cake makers demand this extra flour, the demand causes the price to go up.
Including cracker and pastry manufacturers.
As manufacturers of these products raise their prices to cover their increased costs of flour, customers are likely to begin to buy fewer cakes, crackers and pastries.
However, as the price of flour rises, there is an incentive for mills to grind more wheat and farmers to grow more.
But, since cakes, crackers, and pastries use club wheat, this may incentivise farmers to grow more club wheat and less of the common wheat used in bread making. If bread demand stays the same, this means bread prices also begin to go up because the supply of bread drops relative to the sustained demand, and the feedback loop continues…
Imagine trying to coordinate all of that – it’d fry your brain! (Well, it would mine.)
That’s what prices do.
7. The big problem with government intervention: enhancing proficiency and performance
In a free market, prices rise when the demand for something is greater than the amount supplied at the current price. In economic jargon, this situation is known as a shortage.
On the other hand, prices drop when the amount of something supplied is greater than the amount demanded at the current price, known as a surplus.
Correct price signals mean that consumers and producers adjust fluid situations.
However, sometimes governments impose price controls to stop prices from rising to the level they may reach in response to the ratio of supply and demand. In my opinion, the reasons for this are always political. They are never economic.
For example, in 2017, the UK Government imposed price controls on retail electricity prices. This made good political sense in the run-up to the General Election. Many people think, “Great, cheaper electricity means less money on my bills”.
Cut to Autumn 2021, and the wholesale supply of fuels can’t meet the consumer demand for them, meaning the price rises. This has resulted in many electricity suppliers going out of business because they can’t afford to buy power wholesale to sell it to retail customers.
There’s also the issue that when electricity is cheap, leaving lights on at home is of little personal consequence. However, there’s potentially less available for other people to use.
When electricity is expensive, we ensure those lights get turned off, and the electricity supply can be redirected elsewhere.
Although on the face of it, cheaper electricity sounds good, the wrong signals on price will hinder the smooth functioning of the market, resulting in poor overall market performance.
Higher prices often make for better sharing.
Prices: the balance to the forces of supply and demand
Price vs Real value
I often hear people making comments like, “They’re being paid less than they’re really worth”, or “That footballer is never worth that much”.
Funny enough, I make similar comments myself when I’m looking at share purchases. I comment to myself that a particular share is above its true value, or that another may be a bargain.
However, these are all subjective judgements.
Prices fluctuate continually, as we’ve seen. And because of this, it’s easy to conclude that prices shift from their real values. But, in reality, there is no ‘real level’ because the usual level at any point in time is the result of the specific set of circumstances at that time.
And these change continuously!
When you think about it, if a real value existed, we’d never make any economic transactions with each other because they’d be no point.
When you go out and have a coffee with friends after the school drop off, the value of sitting with your friends and talking over a coffee before work is higher to you than the £3.00 you’ll later complain about paying for it. (Well, I grumble…!)
But, at the same time, the £3.00 the coffee shop receives from you is more valuable to the shop than the coffee is.
Both sides benefit from the exchange.
However, if a ‘real value’ existed, neither you nor the coffee shop would benefit, since what is acquired would not be more valuable than what was given up. So, why bother?
If the coffee shop decides to charge you £4.00 to sit and drink coffee, to try and get more value from the transaction for itself, you’d probably conclude it was trying to rip you off and go elsewhere, or not bother.
For the coffee shop to remain in business, it needs to continue to transact with its customers in a way where both it and you get the value you need from it.
And this is subjective.
The same concept applies to financial securities.
You may have heard of the term intrinsic value, or real value, of a share or company. This value is in the eye of the analyst. Unlike the market price, it is not definitive, and it depends on each particular case.
On the other hand, investors register choices by buying and selling shares, and it’s these choices that drive share price movements.
However, at any one point in time, specific security may be expensive or cheap depending on your own subjective judgements.
And this is why research and a thorough understanding of what you are buying and selling are so important to successful investing.
So, just like making any other purchase, you transact when the time is right for you and your circumstances.
Free economic transactions are never zero-sum because both sides win.
One of the main reasons that prices can’t be maintained at set levels is the presence of competition.
Competition between producers ensures that prices are forced to equality. After all, if you can buy exactly the same thing cheaper elsewhere, that’s where you’ll go to buy it.
In addition, other company resources, such as employees, are attracted to where we’re best paid, usually where the demand is highest for our services.
It’s these relative changes in prices that move resources.
And it’s the main reason why some public sector workers, employed under centralised pay scales, live like kings in some areas of the country and paupers in others.
It’s also the reason for stock market movements between companies and industries. And why do bond markets provide signals of future investor expectations – people put their money where their mouths are!
Prices in different economic systems
If you’ve ever worked in the public sector (i.e. directly for the government), you may be familiar with how its budgeting system works…
In a nutshell, you always ask for as many resources as you can get in next year’s budget regardless of how much you actually need!
You always have a vain hope that by doing this, you may actually get what you want. After all, no one at the top really knows what you need.
This means you get stockpiles of certain resources and large amounts of wastage too.
This is what happens in a centrally controlled system, such as the former Soviet Union.
Economising? What’s that? Pah!
However, in my own business, I’d never order this way. I know what my requirements are, and I order what I need and what I can afford. And this is how free(r) economies, such as Germany and Japan, work. Prices, not bureaucrats, allocate resources.
In the 1960s, there was an infamous bet made between Kwame Nkrumah, Prime Minister of Ghana, and Felix Houphouet-Boigny, President of the Ivory Coast, as to which country would be the most prosperous.
At the time, Ghana had more resources. However, the economy was being run by government administrators. The Ivory Coast, in contrast, had committed itself to a freer market economy where price signals could work their magic.
Cut to 1982…
And the poorest 20% of people in the Ivory Coast had higher real per capita income than most citizens of Ghana.
Fortunately, Ghana learned its lesson and loosened government controls. However, the Ivory Coast did the opposite and, sadly, the two countries’ relative positions reversed.
Limitations of the price mechanism
The advantages of the price mechanism are numerous. But, it has its limitations too.
Some people argue it’s an impersonal way of making economic decisions. And it is. But, to my way of thinking, this makes it more objective and less prone to nepotism or cronyism.
There’s also the issue of some goods and services that are more efficiently and fairly provided by the state. Security and military forces are two examples.
And there’s also the charge of inequality. People with money have buying power, and people without money do not. This is also true. But, only to a degree.
Imagine if the only meat bought by those with money is grass-fed and organically reared in small quantities. How, as someone with fewer means, do you afford to eat meat?
The answer, of course, is there is a market for cheaper meat produced under different conditions. And it is the price mechanism that allows this market to exist.
It also takes time for price changes to filter through the economy, although digital technology speeds up this process.
However, no system is perfect, and the price mechanism offers more advantages and fewer limitations than any other system I’ve come across.
The bottom line…
Economist William Easterly once said that the wonder of markets is that they reconcile the choices of myriad individuals.
It’s so true.
And the price-setting mechanism, which reflects the differences in supply and demand, lets this happen.
Prices tie together a huge network of activities among widely dispersed people.
Few of us are entirely self-sufficient, and we need to encourage others to provide things for us. Prices are crucial in making this happen because they link our interests together.
They also allow us to weigh up the costs and benefits when making decisions.
Frankly, if you understand how prices work, you can understand economics.
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