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What Do Prices “Know” That You Don’t?

According to Prof. Michael Munger, prices (as in, the price of a carton of milk, or a new car) are akin to magic. Prices “magically” convert countless pieces of dispersed, complex information into a single signal that conveys to sellers what they should do to best benefit society. By ignoring the price system, you’re really ignoring the needs of those whom you want to serve.

Prof. Munger illustrates this through an example of two farmers trying to decide whether to plant corn or soybeans. One farmer is purely altruistic; he refuses to acknowledge the role of prices and instead sets about to determine which crop would help society most. He pours over data but finds himself overwhelmed with his impossible task. He makes a guess and plants corn. Unfortunately, there is already too much corn on the market. Not only is society not much better off, but his business fails.

The other farmer cares only about profits. A variety of world events have driven up the need for soy, so the price is higher. He sees the increased price and produces soybeans in order to maximize his profits. He doesn’t care why the price is high, and he doesn’t need to know. All that matters is that he was motivated to produce exactly what humanity wanted. This is the “magic” of the price system – it merges the needs of society with each seller’s desire for profit.

 

Munger on John Locke, Prices, and Hurricane Sandy [podcast]: Prof. Munger discusses how the market responded to shortages induced by Hurricane Sandy


Soviet Food Shortages [chart]: A 1989 chart from the CIA shows that how the Soviet Union failed to feed its citizens in the absence of a price system


The Price System, Part I: Information (video): Learn Liberty video explains the importance of the price system to a well-functioning economy


Is the Price System or Rationing More Effective in Getting a Commodity to Those Who Need it Most? [journal article]: Academic article examines whether scarce resources are best allocated by the price system or central rationing


Steve Horwitz on Walmart's Response to Katrina (video): An economist explains how the price system led Wal*Mart to help the victims of Hurricane Katrina


What’s better: Knowing the price of something or knowing with perfect information how much something should cost?

It’s a trick question.

Suppose there are two farmers – Al Trewis and Moe Cashferme. Each has 500 acres of land that could grow either corn or soybeans.

Suppose I ask what their plans are. Both of them text back, “I don’t know.”

Now suppose we borrowed a crystal ball from some genie and we know everything. Among the things the crystal ball can tell us are that Brazil has had a terrible summer with drought then late floods that wiped out 40% of their soybean crop. It also tells us that new uses for soybean curd have pushed up demand for soy paste all over Asia. Meanwhile, corn crop yields have hit record highs all over the world and, at the same time, several countries ended their corn-based ethanol programs leading to an extraordinary corn surplus.

Our first farmer, Al, has to decide what to plant. Al never wanted anything for himself. All he cares about is doing what’s best for all of humanity. He does research trying to decide which crop will be better for humanity as a whole, but it’s hard for Al to determine which information is most relevant because he doesn’t trust price information and the knowledge that he need is too dispersed, too specific, and too hard to learn.

Now Al knows a lot – but still not enough. He’s stuck at, “I don’t know.” So he makes a guess, plants corn. Al’s put a tremendous amount of time and resources into his research instead of focusing on what he’s good at – running a farm.  As a result, he doesn’t get much corn planted, has a hard time selling the corn he does produce. He has to sell for very little and ends up bankrupt.

Let’s look at Moe’s experience. Since he cares only about profits, he focuses on prices. In early February, the price of corn futures falls sharply, but soy futures indicate that prices for soy delivered in August should be excellent.

Why did this happen? Moe has no idea and he couldn’t possibly care less. Moe sells a large soy futures contract to lock in the high price and plants soy on every square inch of land that he owns. It’s a selfish bet, one that’ll make Moe a lot of money.

Instead of trying to be an expert in all the disparate subjects he’d need to master to have perfect information about the marketplace, he just focuses time and resources on running his farm. And the only other information he used was prices. So he produced a lot of soybeans and did well for himself.

Which of the two did the right thing, the better thing for society? What would the genie with the crystal ball have told us? The genie would have looked at the glut of corn and the shortage of soy that made it so valuable and told us what people need is more soy.

But of course, there’s no such thing as genies in the real world. Information is too dispersed, too complicated, to solve the “IDK” problem through research. There’s just too much to know.

Fortunately, farmers don’t need a crystal ball because prices do exactly what we were hoping the genie would do. Farmers don’t need to know why a price is high or low, and in fact no single person could possibly explain it fully. But by growing the crop that produces the greater profit, farmers can produce the crop that solves the shortage, meets the demand, and satisfies the requirements of innovation.

It’s impossible to attain perfect information about the entire marketplace, which is changing all the time. Prices are a way of condensing all that information to one easily understood signal.

Almost like magic.

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