The Price System, Part 1: Information

Release Date
June 29, 2011

Topic

Basic Economics
Description

Why are prices important? Prof. Daniel J. Smith of Troy University describes the role that prices play in generating, gathering, and transmitting information throughout the economy. Information about the supply and demand of different goods are dispersed among different buyers and sellers in an economy. Nobody has to know all this dispersed information; individuals only need to know the relative prices. Based on the simple information contained in a price, people adjust their behavior to account for conditions in supply and demand, even if they are unaware of that information.

  • Information and Prices [Article]: Donald J. Boudreaux explains the complexity of economies and the vital role prices play in coordinating economic activities.
  • The Use of Knowledge in Society [Article]: Friedrich A. Hayek explains how the market process collects widely dispersed knowledge, which generates prices to be used by both consumers and producers.
  • The Pretense of Knowledge [Article]:  Friedrich A. Hayek’s Nobel Prize lecture emphasizes the importance of knowledge in economic analysis and offers a critical analysis of those who overlook the true nature of knowledge.
  • Where Do Prices Come From? [Article]: Russell Roberts discusses the market forces that determine prices and the process by which prices adjust.
  • I, Pencil [Article] by Leonard E. Read. A classic 1958 essay that illustrates the process of spontaneous order through the story of the creation of a simple pencil.
  • I, Pencil (Video): Milton Friedman demonstrates through the example of a pencil how market prices provide just enough information to encourage social cooperation and prosperity.
  • How Markets Work [Article]: Eamonn Butler provides an excellent short article on the fundamentals of markets and the benefits associated with market transactions (found on pp. 17-25).

The Price System, Part I: Information
Why are prices necessary? The pricing system offers an information generating, gathering, and transmitting process that’s able to call up widely disbursed information that no central planning agency, let alone any individual, can know, possess, or control on their own.
Prices play a key role in transmitting economic information. Without even knowing the intricate market conditions of every good and service produced and consumed and all the resources used to produce them, producers and consumers around the world alter their behavior to even small changes in market conditions via the price system.
For example, tin is a resource used in many of the products we consume on an everyday basis. Yet many consumers and even producers know little about the market for tin. Without knowing the market conditions for tin, producers and consumers will automatically adjust their behavior when there’s a change in price. A disruption in the supply of tin, say a mine collapse, will automatically lead to a rise in the price of tin and products made with tin. Producers don’t need to know why the price has gone up, only that they can now charge more for tin. This leads tin producers to increase the supply of tin by, for example, working longer hours or using more intensive mining techniques. Likewise, consumers, seeing the increase in price, will use fewer products made with tin. As we have seen, both producers and consumers have adjusted their behavior to account for the new market conditions of tin as a response to the change in price.
Prices play a vital role in generating, aggregating and transmitting the knowledge that is dispersed around the world. It would take months, maybe even years, for government officials to evaluate the current production levels of the remaining mines, evaluate new technologies, and decide which mines can produce more tin. Furthermore it is nearly impossible for a government agency to track down all the users of tin and prioritize their use. In a free market, prices adjust automatically to changes in conditions, preferences, and technology, relaying the relevant information to producers and consumers.
Governments frequently attempt to interfere with this formation of prices, either by replacing the price system with a central planning board or by adjusting prices using price controls. Throughout history this has led to scarce resources being grossly misallocated. This is why it is necessary to allow the price system to function free of government interference.