Fundamentally, in a system in which the knowledge of the relevant facts is dispersed among many people, prices can act to coordinate the separate actions of different people.… It is worth contemplating for a moment a very simple and commonplace instance of the action of the price system to see what precisely it accomplishes. Assume that somewhere in the world a new opportunity for the use of some raw material, say, tin, has arisen, or that one of the sources of supply of tin has been eliminated. It does not matter for our purpose—and it is very significant that it does not matter—which of these two causes has made tin more scarce. All that the users of tin need to know is that some of the tin they used to consume is now more profitably employed elsewhere and that, in consequence, they must economize tin. There is no need for the great majority of them even to know where the more urgent need has arisen, or in favor of what other needs they ought to husband the supply. If only some of them know directly of the new demand, and switch resources over to it, and if the people who are aware of the new gap thus created in turn fill it from still other sources, the effect will rapidly spread throughout the whole economic system and influence not only all the uses of tin but also those of its substitutes and the substitutes of these substitutes, the supply of all the things made of tin, and their substitutes, and so on; and all this without the great majority of those instrumental in bringing about these substitutions knowing anything at all about the original cause of these changes. The whole acts as one market, not because any of its members survey the whole field, but because their limited individual fields of vision sufficiently overlap so that through many intermediaries the relevant information is communicated to all.
Hayek continues, “We must look at the price system as such a mechanism for communicating information if we want to understand its real function.” Prices are “a mechanism for communicating information.” Few insights in all of economics are more important than this one. Prices—ever-adjusting market prices—are our indispensable means of communicating to one another knowledge that is radically dispersed among us all, incomplete, changing, tacit, and latent.
Hayek stresses how wonderfully efficient the price system is—it shields us from information overload:
The most significant fact about this system is the economy of knowledge with which it operates, or how little the individual participants need to know in order to be able to take the right action. In abbreviated form, by a kind of symbol [that is, the price], only the most essential information is passed on and passed on only to those concerned. It is more than a metaphor to describe the price system as a kind of machinery for registering change, or a system of telecommunications which enables individual producers to watch merely the movement of a few pointers, as an engineer might watch the hands of a few dials, in order to adjust their activities to changes of which they may never know more than is reflected in the price movement.
I illustrate Hayek’s point to my students at Towson University, where we have excellent lacrosse teams, by considering how and why our lacrosse players might react to the disturbance in the tin market. Do our lacrosse players monitor the tin market? Of course not. But will they adjust their behavior appropriately? Yes, they will, if the price system is allowed to do its work.
We trace an illustrative scenario from tin to lacrosse sticks this way: The price of tin rises, either because “a new opportunity for the use of … tin has arisen, or [because] one of the sources of supply of tin has been eliminated.” Again, “it does not matter for our purpose—and it is very significant that it does not matter—which of these two causes has made tin more scarce.” As the price of tin rises, the makers of tin cans need to charge a slightly higher price to cover the higher cost of tin. Some users of cans, perhaps juice producers, respond to the slightly higher price of tin cans by putting some of their juices into aluminum cans instead. They compete for the limited supply of aluminum cans by offering slightly higher prices for them, and as the price of their product rises, the makers of aluminum cans respond in turn by increasing their output. In order to do that, they need more aluminum; and their increased demand for aluminum (and, of course, the increased demands of other manufacturers switching to some degree from tin to aluminum) tends to bid up the price of aluminum. Because the price of aluminum is a bit higher, the makers of lacrosse sticks, whose handles are aluminum, must charge a slightly higher price for their sticks, to cover their slightly higher costs. And finally, the slightly higher price of lacrosse sticks leads one or two of our Towson lacrosse players not to buy that extra stick he or she has been considering. Lacrosse players in Towson do not monitor the production and use of various metals; they don’t need to. They need only the information they receive through prices to persuade them to adjust their behavior as appropriate to the new relative scarcity of tin, and therefore of its substitute, aluminum.
What is really wonderful about all this—Hayek calls it a “marvel”—is that the lacrosse players—and can makers and juice producers and lacrosse stick makers and aluminum producers—all react as they would if they knew directly of the new scarcity of tin and wanted to be socially responsible. But they don’t know, they don’t need to know, and they need no sense of social responsibility. Prices guide them to appropriate adjustments of their actions. Hayek continues:
Of course, these adjustments are probably never “perfect” in the sense in which the economist conceives of them in his equilibrium analysis. But … the marvel is that in a case like that of a scarcity of one raw material, without an order being issued, without more than perhaps a handful of people knowing the cause, tens of thousands of people whose identity could not be ascertained by months of investigation, are made to use the material or its products more sparingly; i.e., they move in the right direction. This is enough of a marvel even if, in a constantly changing world, not all will hit it off ... perfectly.
With market prices to guide us, we are all led to use resources in nearly the best available ways. We don’t put engineers to work designing trestles and tunnels when they are more urgently needed designing irrigation systems; we don’t use aluminum in spare lacrosse sticks when it’s more urgently needed in cans to replace tin cans made more expensive by some disturbance in the tin market.
Prices are precious. If we are to use scarce resources to satisfy people’s wants in the most economical way—to achieve the greatest possible human satisfaction for what we give up in the process—prices are the knowledge surrogates we rely on and cannot do without.
Should Prices Ever be Controlled?
How far can we push this insistence on the value of market prices? Is it never in the public interest for governments to control prices?
Let’s seek answers to these questions by considering an extreme case—price gouging after a hurricane. Many people condemn those market prices as unjust, and support price controls. For example, after Hurricane Hugo hit Charleston, South Carolina, in September of 1989, prices of many needed goods shot up. Because the storm surge had polluted the city water system, bottled water was in great demand, rising drastically in price. Because power lines were down all over the city, gasoline-powered generators that had sold for a few hundred dollars before the storm were going for several thousand dollars afterwards. Ice that had sold for $1 a bag was selling for $10 a bag.
Should grocers be prevented from raising bottled water prices from, say, $1 a gallon to $10 a gallon? Should hardware store owners be prevented from raising gasoline-powered generator prices from, say, $300 to $3,000? Or is it best for the people of Charleston, generally considered, to let those prices rise, to let the market prices prevail?
In Charleston after Hurricane Hugo, anti-gouging sentiments carried the day politically. The mayor and city council passed legislation making it a crime to sell goods for more than they had sold before the hurricane. The punishment for this crime was up to thirty days in jail and a $200 fine.
Let us leave aside the important philosophical question of whether it is right or wrong to charge s
uch high prices, and focus instead on the economic consequences of letting prices rise sky-high, versus holding them down to pre-storm levels.
Suppose the Charleston politicians had left the markets free and allowed grocers to sell their bottled water at, say, $10 a gallon, up from $1 a gallon. What would that $10 a gallon price have communicated? What would it have “said” to those who first arrived at the stores?
It would have communicated—in the summary form of that shocking $10 per gallon price—the combined knowledge and judgments of many people in and around Charleston as to the extent of damage to the city water system, the amount of bottled water available on store shelves, how long it would probably take to get the system fixed, and how hard it would be to bring new bottled water into the city. To those arriving at the store, the $10 per gallon price would have boiled all this information down to this message: “Clean water is very scarce right now; lots of people want some; don’t take much.”
One excellent characteristic of market prices is that at the same time they communicate dispersed knowledge, they provide an incentive to act on that knowledge. In the wonderful phrase from Professors Tyler Cowen and Alex Tabarrok, “a price is a signal wrapped up in an incentive.” What incentive would the $10 price give buyers arriving at grocery stores, eager to stock up on clean water? Of course it would give them an incentive to buy less, which is exactly the response needed by other people who have not yet had a chance to get to a grocery store. It would give the early-arrivers a strong incentive to leave some water for the late-arrivers. Here again, the market price brings about coordination: while bottled water is precious and scarce, its high price motivates people to share the short supply with others.
By contrast, consider what actually did happen in Charleston in 1989 after the price controls were enacted. People who arrived first at the grocery stores bought all the water they could carry, quickly stripping the shelves. When those from harder-hit areas finally arrived, there was no water for them. Market prices were forbidden, so coordination broke down.
Notice how this phenomenon puts the issue of fairness in another light. Observers of the high price might ask themselves who would buy water at that price? “The rich,” they think, and that seems unfair to people with less money. But if instead we ask how much water people would buy at that price, the answer is that probably all buyers, rich and poor, would buy less than they otherwise would, and thereby leave more for others. The pre-storm price of $1 a gallon was certainly unfair to those who couldn’t get to stores early, because a price of $1 a gallon meant they got no water at all—it was all sold out. Had a high market price been allowed to do its essential job, it would have deterred both rich and poor from buying more than they considered essential, and spread out the available supply among more of the residents of Charleston. In an important way, it would have been fairer for everyone to have a chance to buy some water at $10 a gallon than for a lucky few to buy up the whole supply at $1 a gallon.
What happened when price controls were put into place is really worse than what we have described so far, because some people bought what water they could at the low, controlled price inside Charleston, and then took it outside the price-controlled area to sell it at higher prices. Perversely, the price controls gave people an incentive to move water away from where it was needed most!
Prices provide information and incentives to both consumers and suppliers. What would a price of $10 a gallon have communicated to suppliers, including potential suppliers who would not ordinarily be in the bottled water business? To alert and enterprising people in surrounding states who had the ability to truck water to Charleston, the price would have said, “Bottled water is much more valuable in Charleston than here; take a truckload to Charleston!”
The high price of $10 a gallon would have provided a powerful incentive for people outside the storm-damaged area to bring bottled water to Charleston, and thereby relieve the scarcity and bring prices down. We can imagine college students in Virginia and Georgia hearing of $10 per gallon water in Charleston, renting a truck, buying all the water they could from their local Walmarts, loading their rental truck, and driving all night with precious supplies of clean water. As soon as they open up their truck and start selling, they begin to relieve the scarcity, and prices start heading back down. Indeed, they might find that as the day goes on, and others with the same idea appear, they must offer their water for $9 a gallon, then $6, then $4, and so on. The high price of $10 a gallon creates the incentive for actions that bid it down.
By contrast, what did the enforced pre-hurricane price communicate? It said that there had been no change in the relative desire for and availability of bottled water in Charleston. That message, we might say, was a lie. And it carried no incentive for people to go out of their way to take bottled water to Charleston.
Consider the case of gasoline-powered generators, whose prices went up from hundreds to thousands of dollars before the price controls were imposed. Again, the free-market price—let’s call it $5,000—would communicate that people’s desire for power generation was urgent while the availability of generators was low. The high price would signal potential suppliers of generators to bring them to Charleston, but we can’t really say that the market price would do what it does with bottled water—cause people to buy fewer generators than otherwise. At a price of $5,000, it seems most people would simply have to do without a generator and the electricity it would supply. In this case, it’s appropriate to ask who would buy at that price?
Think about it before reading on to the next paragraph: Who would be willing to spend $5,000 on a portable generator? Try to “think outside the box.” The seemingly automatic response I usually receive from my students is that “the rich” would spend $5,000 for a generator, because they are rich, while “the poor” would have to do without. “The rich” would have the benefits of electricity, then, and “the poor” would not. Try to go beyond this first answer, because it’s not a good one. Read on when you have an answer you like: Who would buy a generator for $5,000?
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One way to approach the question is to consider what kinds of people in Charleston have the most to gain from a supply of electricity and therefore would bid the most for a portable generator. Is that homeowners? Probably not. What would a grocery store owner pay for a generator if she had two thousand dollars’ worth of frozen food in her freezers and three thousand dollars’ worth of perishables in her refrigerated cases, all beginning to warm up? What would a filling station owner pay for a generator if he had five thousand dollars’ worth of much-needed gasoline in his underground tanks, inaccessible because he had no electricity to power his pumps?
Suppose the grocer and the filling-station owners had been able to buy the generators, because a $5,000 price tag deterred any homeowner from buying a generator that was much more useful to the community at the grocery store or filling station. Who would have had the benefit of the electricity generated? Certainly the grocer and the filling station owner would have benefitted, but all their customers would have benefitted, too. Because electricity was much more valuable keeping perishables cold and gasoline flowing, a high price for generators was just what the people of Charleston needed to maintain coordination among them all, by giving everyone an incentive to get electricity to where it could do the most good.
What happened, in fact, when the price controls were imposed and generators could legally be sold for no more than the $300 they sold for before the storm? If you had been a hardware store owner with a couple of generators, what would you have done with them? Again, think it through before reading on.
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What was the effect of preventing “price gouging” on portable generators? I have one illustrative story from my friend Professor Russ Sobel, who was there at the time:
My neighbor was high school best friends, years ago, with the now owner of a local hardware store. The store had two generators. He didn’t get the store open before the p
rice controls took effect. So he was faced with them. He kept one for his family and sold the other at the controlled price to my neighbor (like 1/10th of the free market price). My neighbor’s daughter (who was my age...the “girl next door” cutie) was blow-drying her hair on it, and my dad was going over to use his electric shaver. In the meantime, the gas station, the grocery store, the bank (with an ATM), and K-Mart were all without power.
What a dreadful waste of precious resources!
Summary
Freely-determined market prices are society’s essential means of communicating the vastly dispersed and ever-changing “knowledge of the particular circumstances of time and place.” We should free all our markets because we need market prices to give us this essential information in order to coordinate our various activities. Prices tell us what to do, or how to do it, by telling us indirectly what others know and what they are doing. Prices communicate to all, in a manner usable by all, the dispersed knowledge of all. Without market prices we would face chaos and poverty. With market prices, we cooperate, coordinate our infinitely varied purposes, and prosper.
Supporters of government intervention in markets may object, saying that the knowledge problem of central planning is irrelevant to public policy in countries such as the United States, where comprehensive central planning is not tried, where our economy is largely free. While of course we are free of comprehensive central planning, we nevertheless have lots of individual policies that constitute degrees of central planning. While our governments do not try to do without market prices, as in the old Soviet Union, they impose many policies that distort or even forbid market prices. Such policies inevitably hinder prices from communicating dispersed knowledge accurately. To that extent, such policies are a problem.
Hayek writes that “we must look at the price system as such a mechanism for communicating information if we want to understand its real function—a function which, of course, it fulfills less perfectly as prices grow more rigid.” When public policy makes prices more rigid or distorts prices away from market-determined levels, that policy impedes the communication function of prices, reduces the coordination among different people that market prices make possible, and thereby reduces overall well-being.
Free Our Markets Page 5
