More featuring David Sharp»

by David Sharp, Founding President of the Australian Adam Smith Club (Melbourne) and author of Economic Simplicities

It is difficult to exaggerate the importance of prices in the working of a market economy. Such significance is a consequence of the fact that voluntary trade is a positive sum game. By definition each party to a voluntary exchange is better off than he or she would otherwise be if such exchange did not take place. The price is the measure of when such exchange can or will occur.

What is a Price?
A price is the amount of money required to purchase a specified quantity, weight or other measure of a good or service. A broader definition would be that it is the consideration required, expressed in terms of one thing, to acquire a quantity of another eg 2 apples for 5 oranges. The economic advantages of price being a monetary concept however are manifest; it provides a common denominator and means of comparison

Market Economy
A market economy is a country or region in which investment, production and distribution decisions are based on the interaction of supply and demand and wherein the price of goods and services are set by freely fluctuating prices within a market. It involves two fundamental concepts; viz property ie that things belong to or are owned by someone, and contract ie that parties can agree and set the terms on which such property will be exchanged and transferred. The alternative to a market economy is a command economy, wherein such decisions are centrally planned and set, and imposed from above

Presently there exists no example of a purely free market economy. There are a variety of market economies which function with a greater or lesser amount of government guidance, regulation and control. Most modern economies tend to be of this sort, and are perhaps more accurately referred to as mixed economies. Apart from addressing what are perceived to be the shortcomings and failings of markets, some people are resolutely opposed to markets on the basis that markets create inequality, and for that reason prefer a command economy. There are however no absolute command economies totally free of markets. Even in extreme socialist economies, the shortcomings and problems that appear as a result of government failure are typically addressed by so-called “black markets”.

The Price System
It is prices that perform the essential function of coordinating market activity. The world contains literally trillions of items of potential use and value to a myriad number of persons in an infinite variety of ways, the overwhelming majority of which are or would be totally useless. The free interplay of prices creates a system that enables each potential use of such item to be evaluated and for its price to reflect the optimum use, to which it is thought each such item can or could be put.

So seamlessly and efficiently does the price system work to coordinate market activity that most people are unaware of its existence or of the significance of what it does. Yet each day billions of people living in market economies are fed, clothed, entertained and otherwise provided for by such coordinated markets. Typically people become aware of such coordinated market activity when it fails, such as when shortages occur. Usually this happens when something takes place to prevent or hinder the free fluctuation of prices. In organizing market activity the price system essentially performs 3 functions. Firstly it transmits information. Secondly it provides incentives for people to pursue and achieve the most productive use of resources. Thirdly it determines who gets how much of the income so generated and distributes it accordingly.

Prices are signals that transmit information. If the price of an item rises it is an indication that there has been a change in the supply [a decline?] and / or in the demand [an increase?] for such item. Conversely if such price falls. Those with an interest in such item, whether as producers or consumers, are thereby alerted to such possibilities and able to plan accordingly, including whether to enter into, increase or decrease production, to purchase more or less, to conserve or to hoard. Moreover, by the operation of the futures markets, those with an interest in such item are able to ascertain how far and to what extent such change is likely to continue into the future by ascertaining the present price for future delivery of such item, and plan accordingly.

Prices provide the incentive for those living in a market economy, whether as producers or consumers, workers or renters, to act. Changes in price, whether in general or relatively, provide the incentive for people to make appropriate lifestyle changes. For instance a fall in the price of minerals generally could be expected a produce a switch in interest of both workers and investors from mining to agriculture or perhaps towards manufacturing. On the other hand a fall in the relative price of coal to iron ore would provide an incentive for a shift from a focus on coal mining to a focus on iron ore mining, or perhaps a shift in population from Queensland to Western Australia.

Distribution of Income
This is the most controversial of the 3 functions of prices. In a market economy the income that an individual receives is derived from the price set by the market on what he contributes to the productive process, whether by way of land, labour or capital. In virtually all market economies the vast bulk of the population receives their income from wages and salaries for personal services. This has resulted in much dissatisfaction with the distribution of income as so generated by the operation of market prices and has created calls for the distribution of income to be separated in some way from the other 2 functions, or, at the very least, for their to be a compulsory redistribution of the income otherwise so derived.

The efficiency of a market economy depends greatly on the integrity of the price system. Anything that interferes with the free fluctuation of prices is detrimental thereto. Inflation, particularly severe inflation, is especially damaging.