The Vital Role of Prices

The legend says that in the 1980’s a Soviet official asked economist Paul Seabright who was in charge of London’s bread supply. The economist answer was, ‘nobody’. That’s of course true, there’s no single person in charge of the supply of essential goods in a market economy.

The answer to that question is, as Leonard Read’s story “I, pencil” describes, a complex and intertwined network of people and businesses that delivers the amount of goods and services required. The main tool they all use to find out what’s required is the pricing signal.

Prices are the most essential tool for the market economies and in most cases, they are not designed or controlled by a central authority or government, they are just the result of spontaneous order of dispersed market forces.

 

A simple form of vast knowledge

Since economist Friedrich Hayek writings, prices have been seen as the free and efficient nature of market economies, before then nobody paid much attention to its nature, it was taken as a given, part of the natural order of things.

Hayek studied the problem of knowledge and information in markets, his central thesis being, the market price system is essential for communicating information and coordinating transactions wherever knowledge is dispersed, and the future uncertain.

In that sense, market prices are a spectacularly compact and reliable source of information. A single number that condenses all the relevant current macroeconomic information; the existing supply, the cost curve, the average costs of transport, labour, energy and capital intensity, the average of forecasts and expectations as of today, the existing demand, the value and volume of stocks and inventories, and the weight each variable has for market players. A change in any of those will inevitably change the price.

And this is the extraordinary thing about prices, such vast amount of macroeconomic information can’t be held by a single individual or group. A single agent can’t possess a complete knowledge of a competitive market that would guide them on their decisions. The signalling system of prices though, in a perfect competitive market, do provide this to each agent’s decisions.

Hayek said,: “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, that is they move to the right direction.”

This is the “the price system as a kind of system of telecommunications which enables individual producers to watch merely the movement of a few pointers”

And Hayek again: “The most significant fact about [prices] 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, only the most essential information is passed on and passed on only to those really concerned”

 

Certain requirements

Not all is so simple of course, commodity boom and bust cycles and financial crisis, have revealed that the price system, even in a relatively free and liquid set of markets, can give profoundly distorted signals.

Prices do come natural to markets, but for a market to have an effective price signalling mechanism (or to have perfect information), certain conditions are required; transparency, liquidity, information symmetry... by its nature, many commodity markets do not feature these conditions.

One notable criticism of perfect information markets was put forth by Grossman and Stiglitz in 1981. They argued that markets cannot achieve perfect efficiency when it comes to information. The act of searching for and gathering information about market prices always incurs a cost, making arbitrage expensive and preventing markets from seamlessly conveying all available information. Consequently, enhancing and optimizing the efficiency of information transmission becomes crucial for both market efficiency and its participants.

 

Information costs

In 1997, out of the coast of southern India, in Kerala, local fishermen were, as they always did, facing the following dilemma; every late afternoon after a catch they had to decide at what port they would deliver their catch. They had no information about what the supply was at their closest port nor the other ports of the area. They didn’t know the best price they could get for their catch. Because of fuel costs and time restrictions, they only had one shot. In many cases, the fishermen chose the wrong port, in not few cases it was even worse, the catch had to be dump into the sea because the market chosen was saturated.  Harvard economist Robert Jensen studied and surveyed that market*, on average 7% of the catches were dumped. That was highly inefficient, Jensen reported that there were days when catches were dumped on one port and on the next port buyers went home empty-handed.

But in 1997 a disruptive technology changed all that, mobile phones were introduced in the region. Fishermen now called ports while still on sea and got the up-to-date prices at all the regional ports. They could then take an informed decision about where to head their boats.

Jensen found that now waste disappeared and price differences between ports dropped hugely as the “law of one price” would have predicted.

Everyone benefited, fishermen profits went up on average by 8% and the average price at ports went down by 4% according to his study. This efficiency effects are still enjoyed today.

This illustrates perfectly the positive importance of information in markets, and how they improve efficiency in imperfect markets and so everyone’s welfare.

 

End quote

To end this article, nothing better than a quote from economist Douglas North, 1993 Nobel laureate in Economics:

“Economic growth throughout history could only be realized by creating an institutional and organizational structure that would induce productivity enhancing activity. […] A source of improving productivity that lowered transaction costs and information costs was the printing of prices of various commodities […]” **

 

 

 

*  “The digital provide: information, market performance and welfare in the South Indian fisheries sector” by Robert Jensen, QJE, Aug 2007.

** “Institutions and productivity in history” by Douglass C. North, Washington University, St. Louis, 1991