The Language of Price
We are now better prepared to resume discussion of the manner in which capitalism leads toward solution of the economic problem. As we recall, the right to private property presupposed by a market economy entitles both producers and consumers to make decisions regarding production and consumption. All production in a market economy is financed by the entrepreneur’s personal savings (his “capital”) or resources he can persuade other private individuals to lend him. Such capital, as we have seen, is acquired by raising personal productivity above the level of subsistence and saving rather than consuming the surplus so produced. Resources, however, including capital resources, are scarce by nature. Producers must thus be vigilant in employing their personally limited resources—their savings or capital—in the production of only such goods as are actually demanded by market participants, that is, consumers. In a market economy, producers are free, within the bounds of law, to produce as they see fit. Those who produce goods and services that consumers do not want, however, will be unable to sell them. Such production errors are undesirable from both the individual producer’s point of view and that of society as a whole. A producer who makes wrong production decisions will personally suffer negative consequences. More particularly, he will suffer a loss rather than earn a profit, which means he will partially or totally lose his capital—the initial resources he invested to produce the goods in question. Such a producer, however, harms not only himself but also the greater good: he has wasted scarce resources that could rather have been employed in the production of goods or services that meet the actual needs and desires of his fellows.
Every production decision thus entails risk. Producers in a market economy can never be certain that their goods or services will in fact be desired by consumers. If potential buyers reject their offerings, they stand to suffer loss, loss of their personal resources. Producers thus have every incentive to make correct decisions, that is, produce goods and services that other individuals will voluntarily purchase. The risk inherent in every production decision is countered by the potential of reward. A producer who makes the right decisions—produces goods and services that other persons actually want and do purchase—stands to earn the reward of profit. Indeed, in a market economy, the possibility of earning profit is the principal motivation for production in general; the principal disincentive is of course the ever-accompanying threat of loss. Such incentives and disincentives are crucial elements of the market process. They foster rationality in economic decision-making by providing a self-regulating or self-enforcing mechanism that encourages careful utilization of scarce resources and discourages their waste. Profit and loss play a central role in the discovery of the “best” possible utilization of limited resources, defined, as we recall, as the most efficient or least-cost method of producing goods and services that consumers, in their own subjective judgment, actually need or want.
The question, however, remains—how is the producer to know which goods and services to produce, that is, which of myriad possibilities will actually be desired and purchased by consumers and whose production will yield profit rather than loss. In a free market, consumers cannot be forced to purchase any good or service; voluntariness, freedom, is the essence of market exchange. The prohibition of force means that no seller is permitted to put a gun, literal or figurative, to a potential buyer’s head and demand his business; every buyer is free to purchase or not purchase as he wills. Thus producers must take care to bring to market only those items that appeal to consumers in such a way that they will voluntarily exchange their personal, and limited, resources for the sellers’ wares. For this reason a market economy generates an astonishingly wide variety of goods and services, tailored to the individual preferences of consumers with dramatically different tastes. Producers, motivated by the possibility of profit (and fear of loss), strive to fill every possible niche for which there may exist potential buyers. The success of their efforts, however, depends not only on creativity and foresight but also the indispensable guidance provided by the impersonal forces of the market. More particularly, producers in a market economy are invariably guided in their production decisions by the key such force—the existence of a freely formed structure of relative prices.
“Prices,” as previously observed, represent a kind of language, one that every normal person comes to understand without formal training or study. As the economic problem, at bottom, is a knowledge problem, so the price system, at bottom, is a carrier of knowledge, a system of communication that transmits relevant economic information spontaneously throughout society by means of the abstract signals or symbols called prices. The information summarized or condensed in relative prices is precisely what permits producers to know which goods and services to produce and consumers to know which goods and services will best meet their individual needs and wants, in line with the constraints imposed by their personally limited resources. Moreover, it is fair to assume that most people want to be good stewards of the earth. The knowledge and information embodied in prices serve that end by encouraging the optimum utilization of the scarce resources of the earth, that is, production of the goods and services most highly valued by members of society and, moreover, by the least-cost, most efficient method, with minimum waste of limited resources. Such can only be achieved if market participants, producer and consumer, possess accurate information regarding the relative scarcity or abundance of resources as well as the level of demand for particular goods and services. The only means to obtain such crucial information in the complex extended order of modern society is the language of price.
Price Formation
The next important issue concerns the manner in which prices are formed in a market economy. The prevailing relative price structure in a capitalist economy is formed as an unintended consequence of the independent actions of millions of individuals, those who participate in any form of market exchange, whether as consumer or producer or both. Indeed the vast majority of individuals wear both hats, that of consumer or buyer, and, if employed, that of producer or seller. Whenever an individual purchases or sells any good or service, he is not only affected by, but also affects, its price. It is obvious that every individual is affected by the price of an item when acting as a consumer; price is almost always taken into consideration when contemplating the purchase of any good or service. It is perhaps not as obvious, but just as true, that the price of any item is also affected by the action of the consumer, by his decision to purchase or not to purchase a particular good or service. The greater the number of individuals who purchase a particular item at any point in time, the greater the upward pressure on the price of the item in question, at least in the short run. In the formal language of economics, ceteris paribus (all other things remaining equal), increased demand leads to an increase in price. Conversely, the fewer the number of individuals who purchase a particular item at any given time, the greater the downward pressure on the price of the item in question, at least in the short run; ceteris paribus, decreased demand leads to a decrease in price. The source of the price movements in both cases, increase and decrease, is the voluntary choice—to buy or not to buy—made by individuals in their role as consumers. When consumers increase their demand for a product, its price tends to increase; when they no longer want it, its price tends to decrease.
Demand, however, is not the sole determinant of price; supply considerations also play a major role. Initiation of a change in relative prices can arise from either the “demand side” or the “supply side,” from either buyers or sellers. Buyers exert upward pressure on prices, as said, when the general demand for a product increases and also through competitive bidding (offering a price higher than the seller’s asking price). Sellers can affect prices by raising or lowering the asking prices for the particular products they sell, within limits. Producers are not absolutely autonomous in this regard; they cannot charge any price they want if they hope to remain in business. Most producers, for instance, have
little control over the price of the inputs they use to produce their final product. They are “price takers” who must purchase the necessary inputs at prevailing market prices, which are affected by various factors beyond the control of an individual producer.
Suppose, for instance, that the price of an essential input rises due to a decrease in its availability (supply). Perhaps unfavorable weather has caused an unexpected failure of the Columbian coffee crop, decreasing this year’s world supply of raw coffee beans. There are not as many coffee beans available for purchase this year as last year; not everyone who purchased them last year will be able to purchase them this year. Supply has decreased. One response will be competitive bidding among purchasers. Those buyers who most urgently desire the coffee beans may offer a higher price than those whose desire is less urgent, thereby exerting upward pressure on their price. Such an increase in price can also arise from the actions of sellers or producers of the beans. The unanticipated decrease in supply means that demand now exceeds supply, that is, more buyers exist than can be accommodated by the existing supply. Sellers thus can reasonably expect that some buyers will be willing to pay more to obtain the relatively limited supply and raise their price accordingly. In either case, whether the upward pressure on the price of coffee beans arises from buyers or sellers, all firms that use coffee beans in the production of their final product will have to pay more to obtain that input. Starbucks’s production costs will increase. A producer such as Starbucks will usually attempt to pass such additional costs on to their customers, resulting in an increase in the retail price of the final product; consumers will have to pay more for Starbucks coffee. In the language of economics, ceteris paribus, a decrease in supply leads to an increase in price. Conversely, the price of an important input may fall. Perhaps exceptionally favorable weather produces a bumper crop of coffee beans, increasing the world supply and thus decreasing the cost. In a competitive market, sellers will pass these reduced costs on to the consumer and the price of the final good will fall. Ceteris paribus, an increase in supply leads to a decrease in price.
Price formation, then, results from the ongoing daily activities of market participants, in their roles as both producer and consumer. All consumers and producers of any good or service fluently read and speak the language of prices. In their role as consumers (a role simultaneously played by most producers, who are consumers of the inputs employed in their production processes), individuals announce, through their purchase or lack of purchase, their approval or disapproval of the manner in which scarce resources are being employed. Every individual who actually purchases a good or service is implicitly expressing approval of such usage, evidenced by his voluntary purchase of the good in question. The joint purchase of the same good or service by many individuals expresses widespread social approval of this particular use of scarce resources, an approval which manifests as upward pressure on the price of the good or service in question. In the same manner, every individual who refuses to purchase a particular good or service is implicitly expressing disapproval of the manner in which scarce resources are being employed, a judgment which manifests as downward pressure on the price of the unwanted item. Through the language of prices, consumers tacitly speak their minds. They tell producers either to “stop” or to “go,” whether they want or do not want the fruits of his production, whether they approve or disapprove of the manner in which he is employing scarce resources.
Producers, also fluent in the language of prices, will hear their customers loud and clear. In a market economy, they heed such complaints not because of benevolence or concern with the common good but because they have no other choice. In a capitalist economy, the income of each and every producer is derived solely from the voluntary purchases made by his customers. If individuals utterly refuse to purchase his good or service, his income will fall to zero. Reduced sales will result in reduced income, possibly to the point of actual loss. The only way producers can avoid such loss is to produce goods or services that other persons actually want to purchase, the knowledge of which is conveyed to them through the language of relative prices.
Further Price Considerations
It is worth repeating that in a free market all purchases are voluntary; people cannot be coerced or forced to buy a good or service they do not want. We have also seen that employing scarce resources to produce goods and services that members of society do not value is wrong and wasteful from both an economic and social point of view and should be discouraged. Such a disciplinary function is admirably performed by a market economy. An individual or firm that wastes scarce resources by producing goods and services that other individuals do not value will be penalized not by government or law but rather the impersonal forces of the market. More specifically, such producers will incur losses (costs greater than revenue), which, if continued over time, will eventually force closure of the business. This spontaneous or automatic feature of the market process has been described as a self-regulating “feedback” mechanism that permits producers to know whether they are utilizing scarce resources wisely or foolishly. A seller who is doing the right thing—using scarce resources to produce goods and services people actually want—will be rewarded by increased sales and profits. A seller who is doing the wrong thing—wasting resources by producing goods and services people do not want—will be punished by decreased sales and losses and eventually forced out of business. Such is highly beneficial, if not for the individual producer, then for society as a whole. Producers who consistently make losses have proven by that very fact that they are not capable of directing scarce resources toward their best possible uses. Such producers should not be permitted to continue such resource misallocation, such waste of scarce resources, and market forces ensure their inability to do so. They will suffer losses, perhaps consume their capital, which means they no longer possess personal resources available for investment and production. The harm they have done is limited to their previous malinvestment.
Moreover, producers in a competitive market economy must strive for efficiency, that is, to produce their goods at the least possible cost. The concern with efficiency, like the concern with consumer taste and preference, is not due to kindness or benevolence but rather market necessity. A producer who is able to produce a particular good or service at lower cost has a competitive advantage over producers who use higher-cost inputs or methods: the former can charge a lower price for the good in question. Ceteris paribus, a decrease in price leads to an increase in demand; consumers will switch from the higher-cost producer to the lower-cost producer. No one must force or command producers in a market economy to make the right decisions—produce the goods and services people actually want with the least waste of scarce resources. They are led precisely in this direction by the impersonal forces of the market, in particular, the signal of profit or loss conveyed by freely forming relative prices, themselves a product of subjective human preference in conjunction with existing conditions of supply.
Capitalism or the market economy is often said to be characterized by consumer sovereignty. Such a concept refers to the fact that, ultimately, consumers guide production decisions by signaling their desire or aversion for particular goods and services via the language of prices. In a market economy, as mentioned, producers are of course free to produce whatever they want (within the bounds of law or regulation) but there is no guarantee they will be able to sell their goods and thus stay in business. Producers in a market economy must strive for profit, which is crucial to survival of their firm. Profit is certainly in the interest of the producer, but it can only be achieved by considering the interests, indeed catering to the preferences, of the consumer. Producers who fail to take their customers’ preferences into account are punished by lack of sales and, ultimately, losses. Only those who correctly anticipate consumer needs and wants, and can satisfy them at the least possible cost, will flourish in a market economy. This is good from the perspective of both individual consumers and society as a whole
—scarce resources should not be wasted by producing items that people do not value or at higher-than-necessary cost. The beneficent harmony of interest between producer and consumer characteristic of market exchange arises from the fact that profit can only be gained by accommodating the tastes and preferences of the buyer.
Let us recapitulate the argument thus far. The information conveyed through the language of relative prices permits “the market” to solve the first aspect of the economic problem—what to produce, and how. Producers know what they should produce, and with what inputs, because they can base such decisions on accurate information regarding conditions of demand and supply conveyed by the abstract language of relative prices. Prices tell producers what consumers actually value and also provide information about the relative scarcity or abundance of the inputs needed to produce the final goods and services. The information condensed in the relative price structure, moreover, permits producers to calculate profit and loss, the signals that indicate whether or not a given good or service is economically desirable to produce. An economically desirable good is one whose production yields a profit, that is, whose cost (the value of the resources necessary to produce it) is less than the revenue yielded by its sale (the value imputed to the good by the consumers). Producers can only perform their function—the direction of scarce resources toward least-cost production of the goods and services desired by consumers—if they have access to the information embodied in a freely formed structure of relative prices. Without the guidance of relative prices, producers would have no way of knowing either the needs and desires of consumers or the best—least wasteful—methods of producing them. They would be operating in the dark.
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