Why prices are good !— yes, even high prices


In a market-based economy, prices are determined by the market forces of demand and supply. This price discovery is usually considered the most significant factor in favor of such an economy versus a centrally controlled economy.

But why is that? Prices are signals to the people involved in an economic transaction. If prices are incorrectly determined in a market, it will incentivize the participants to take action in a way that will benefit them from an impending price correction. Without these signals, participants will not know about changes in the market soon enough to balance the demand or supply.

Consider a market for bread where the government has set a price for the entire market. Usually, this price is artificially low to support the population or the buyers. All the bread will be sold at a government-mandated price. Producers who do not make the bread at a cost below the set price will inevitably have to leave the market. This would mean that they will employ cost-cutting measures like using low-quality wheat or reducing salaries. Low-quality wheat will have poor nutritional content and will be a bad outcome for all the buyers. Lower salaries would mean that the sector will not attract talented employees & hence bread producing industry as a whole will suffer. All firms will simply produce the simplest, low-cost bread so that there will be maximum profit for them. There is no reason to invest or innovate because a high quality product will fetch the same price as the poor one. Consumers are left with little or no choice but to buy a standardized commodity.

This scenario can quickly deteriorate if the price set becomes so low in relation to costs that most of the producers will suffer a loss. They will have to shut their units, lay off employees, and stop selling bread. When this happens, there would be a bread shortage. People simply won’t get bread because there is not enough being produced. Now, in theory, a centrally managed economy would never allow such a situation & before the costs of the producers could go higher than the set price, they will intervene and increase the set price which covers costs & profit margins. But in practice, it is extremely difficult to do. We have seen ‘great’ centrally managed economies perish — think about the soviet union, and East Germany as some reference points.

How will the prices have behaved had it been a market-based economy in this example? If the government had not set the price, different firms with different cost structures would have different prices. They will compete to offer the best product at the lowest price for the consumers. Different consumers can buy different bread at different prices. If a product has a higher price, it means that consumers are willing to pay more for a product with superior taste. If the costs of the producers rise, they can increase the prices of their products. If then the demand for their products decreases, they will find out ways to reduce costs without compromising on quality because they know their customers can leave them for competitors for poor quality.

What happens if the prices of bread are increased to such a level when most people can’t afford them? This is a major concern for a government that typically implements a price ceiling for any product. Well, we just saw how centrally managed pricing does not work. If prices are left as it is, prices will self-correct. A high price will incentivise participants to set up new bread manufacturing units. More units will produce bread and for a brief period, get amazing profits due to a higher price. As more and more units start bread manufacturing, production will gradually increase and will lead to lower prices. This will happen till the abnormally high prices go away.

Prices, low or high, act as stimulants of economic action. It is important to let them do their job instead of trying to manage them. Prices give incentives to producers and important information to the buyers, in some cases protecting them from poor quality products. Naturally, some forms of markets can take the shape where despite no central management, it can be to the detriment of consumers but there are separate checks and balances that the government can implement to avoid those situations. Governments should not be in the business of determining prices but in implementing policies that allow free markets to operate fairly.

Prices in a nutshell allow everyone to maximize their profits in a transaction. The producer gets a profit and the consumer gets a good product at an affordable price. Legendary economist Adam Smith, aptly puts it as —

It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard for their own interest.

Without accurate prices, everyone is throwing darts in the dark and the system will be most likely worse off in the long run.