The language of the economy: prices

50 Things That Made the Modern Economy is looking for a 51st thing. Below is the email I sent them.

Hey Tim and everyone involved in making this fantastic project!

My suggestion is a bit abstract and even a bit nerdy for an economics podcast… The price system. Because we see prices all around us we think of them like fish think of water and miss the miracle. The price system is only bested by spoken language in allowing peaceful and productive cooperation between strangers. Both are further enhanced by their written equivalents: accounting and writing.

Consider language: it lets you and I imperfectly) exchange experiences and knowledge so that our community as a whole can learn faster than any isolated individual.

Prices, emerging as a byproduct of market competition, send information about the relative scarcity of different goods. We need this information to use resources wisely. Prices wrap together the following information:

  • Consumers’ subjective valuation of goods. I.e. how much other stuff (at the sorts of prices we each expect we can find) we are willing to forego of how much extra work we’re willing to do.
  • Expert producers’ best guesses about the productivity of alternative production methods.
  • The difficulty of getting the product into the hands of consumers.

Prices solve the problem of credible commitment by making us put our money where our mouths are. If you ask if I’d like a Ferrari I tell you yes, but my actions say otherwise. I’d get value from it if someone gave me one, but I’m not willing to give up enough value to make it worth Ferrari’s effort to actually make one. This means that we can save that steel and plastic for some more important use (or at least a use that brings a warm fuzzy feeling to the heart of a consumer*). In other words, prices give us the information we need to make efficient use of our scarce resources–trading off costs and benefits to maximize value (at least the value of products we buy and sell on markets).

And this system tracks back through the supply chain so that oil futures prices can still reflect consumers’ values by way of the bidding activity of producers buying inputs for the end goods we actually care about. This is amazing because it means we can efficiently plan for the future by relying on the wisdom of crowds.

It’s not perfect**, but the price system wraps incentives and information together into a simple number that reflects society’s collective estimation of the marginal value of nearly everything we use that relies on the cooperation of strangers. It combines the views of many people, but it takes more seriously the estimations of people who have done well in the past. Sometimes that’s by luck, but at least sometimes it’s superior knowledge and foresight… Until the old guard is finally bested by innovative upstarts building on the last generation’s accumulated wisdom.

When it’s working properly–which is most of the time in the western world–the price system allows communication that can’t be done in any other way. When humanity learned to use symbols to share knowledge it was a paradigm shift. The price system was too. Smith told us that the division of labor (and hence productivity and wealth) is limited by the extent of the market. That is, our wealth is limited by how many people we can cooperate with. We can’t cooperate with distant anonymous strangers without a way to credibly communicate value which is exactly what prices do.

*Or temporarily abates the consumer’s existential dread… All I can say as an economist is that you might consider talking to a specialist before committing to an extravagant use of resources to fill an unfillable hope in your heart.

**As a tool, the price system can only reflect our values. I don’t want you to think I’m saying it’s more important to make money than to share a sunrise with your child. The exact opposite in fact–that’s what supply curves are for. They reflect each of our subjective experiences of the value we get at home and in the public square. As our economy grows more productive, and as we get more in tune with our spiritual sides, we are better able to say that “actually our time is worth too much to give up that 80th hour of weekly work time.”

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