Wednesday, April 22, 2015

Do We Want High Prices or Low Prices?

By Fernando Herrera-Gonzalez

In an almost daily debate over economic and monetary policy politicians complain if prices — such as home prices — do not rise, and some complain if they think other prices — such as health care prices — are going up too much. This situation begs the question: do we want rising prices or falling prices?

The truth is that prices are neutral, at least as far as social welfare is concerned. Constant changes in prices indicate that an economy is working to coordinate the wants and needs of consumers and entrepreneurs. They are the mechanism by which buyers communicate with sellers, and vice versa.

For this reason, before we can understand the role of prices, it is important to distinguish between “prices” and “offers,” even if in our daily dealings we tend to conflate both terms. A price is the ratio at which two commodities have been interchanged by two individuals in a concrete transaction. However, the “prices” we see in a supermarket for each of the available goods are not actually prices, but offers, and will only become prices if the good is actually bought. If the “price” for an apple is set at, say, 100 euros per apple, and consequently no one buys any apples, it would be wrong to say that the price of an apple is 100 euros, just because the supermarket tried to sell apples at such a price.

With this in mind, let’s try to answer the question: does social welfare improve, when prices increase or when prices decrease? If the price of a concrete good rises, it is clear that people who already own the good will be better off. Those people which have the means to produce it, be it labor or assets, will likely profit from the increase too. Conversely, people who do not own the good will be worse off, especially if they are planning to buy it in the short term. The contrary will of course happen if the price goes down.

So, what is the balance for society? There is no answer. In fact, from the point of view of “society,” the rise and fall of various prices are simply the marketplace at work. For concrete individuals in specific concrete transactions, there are costs and benefits, but in relation to “social welfare” or “the economy,” we can conclude nothing.

The Role of Prices in Society

However, this is not the end of the story: prices have also a fundamental role to play in the market. They are the signals by which entrepreneurs guide their decisions on investment. As such, prices are an indicator of the relative scarcity of a good with respect to its uses.

If a price rises, this means that a good is more valued by society, and conveys the signal to entrepreneurs that more resources should be deployed to the production of that good, because this is what society is currently demanding. Conversely, if a price decreases, the good is losing value for society, and resources should be moved from its production to other more productive uses. This process, as explained, is not automatic, but driven by entrepreneurs using prices as signals.

When We Mess With Prices

What happens if prices are tampered with through price controls or other coercive government controls? Of course, the first effect will be that some individuals will lose and others will win. For example, if prices are not allowed to increase, people owning the product — or the means of production — will lose wealth, while people intending to buy it will increase their own wealth. Politicians normally think that this is good for “the people,” because — in the minds of many populists — firms are “rich” and this action re-distributes wealth from “the rich” to other people.

This may be good for the individual consumer for a particular transaction; but individuals are much more than consumers: they may be shareholders of firms, or they may have a pension plan which is invested in the firm, or they may work for the affected enterprise or for any of their providers upstream in the value chain. So, in the end, it is not even easy to clarify if a concrete individual, much less society, is better or worse off as a result of the price control.

However, this is not the gravest effect of price tampering. The biggest problem is that disrupting the price system jams the price signal system, and thus entrepreneurs are hindered from calculating how they should devote resources to a particular enterprise. The entrepreneurial process will go on, but the resources will be taken to the wrong places, impoverishing the society with each investment.

One other thing should be considered: entrepreneurs, being human, may make mistakes. An entrepreneur may offer a good at too a high “price” and then find he is not able to sell enough units to make the investment worthwhile, being forced to bring the price down in order to increase the sales. This does not make the initial price wrong and the new price right: it just means that the entrepreneur is reacting to the new information acquired after the first attempt. If further information comes along, the price may be revised again, be it upward or downward. This is the essence of the entrepreneurial process, to react to changes in the environment trying always to adapt to the new preferences shown or anticipated by individuals.

To maximize this essential interplay between consumers and producers — through which consumers exercise their control over the marketplace and even society at large — the goal needs to be freedom in prices, and not “high” prices or “low” prices. Tampering with prices prevents them from doing what they’re supposed to do, making the process of resource allocation harder and more ineffective. And this would definitely harm all of us.

The above originally appeared at

1 comment:

  1. Debt is BETTER than cash? …Who’s running this asylum anyway? Author : Bill Holter

    Now, “interbank” lending has gone into negative interest rates which is beyond lunacy. Banks which are theoretically run by “smart” people are paying to lend and of course willfully being paid to borrow. The only explanation I can come up with is that collateral has become so scarce that a short squeeze has resulted. Any institution that needs collateral is forced to pay the market rate which now includes locking in a guaranteed loss. Business in Europe has become so poor, no one can, much less wants to borrow anything. “Debt saturation” is where we came from in 2007-08 and further down the rabbit hole to where we are now, inverted interest rates on ALL levels …now even between “pros”?

    I view what is now happening as “eating into the bone”. Debt has become so highly priced, locking in guaranteed losses is now seen as “wisdom”. When viewed in history, the current mania will not be seen as a tribe or nation gone mad, it will be seen as the entire human population losing sight of their senses and allowing the lunatics to run the insane asylum. I have no idea what the event will be to wake up the world but the event is out there and its realization will be akin to awakening from a nightmare in a cold sweat.
    “Debt is better than money” is becoming the current belief in the world. In fact, with negative interest rates it can be said the world now values debt greater than money. This cannot be so because of the simple fact that actual paper notes can be held out of the system and not “discounted”. How can owning debt today which promises less currency in the future be worth more than more currency today? The fear of loss is so great that currency itself is being discounted versus debt.

    If you think this through, it says “everything is worth nothing” because the currency itself is bad and losing confidence.

    Maybe this is why we are seeing a push from all around the world to go “cashless” and fully digitize? This would be closing and locking the only remaining door other than making precious metals illegal. The only way for this to be “normal” is if the lunatics are running the asylum …they surely are!