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Sunday, July 19, 2009

When is the price right and why does it matter?

Prices annoy us. If we want it, whoever is selling it wants too much. If we are desiring to sell something, we are generally disappointed if we can't get our asking price, or we kick ourselves that we did not ask for enough if we too easily find a buyer.

At a deeper level, what do prices mean? Prices relate to money which is another story, both simple and complex. Money is simply a common placeholder which allows us to quickly show what we value. We are willing to devote much of our lives to work in order to receive money which allows us to obtain things we need as well as things we desire. If we are selling something which required many hours of our work to produce, we desire to get a reasonable return on our efforts, otherwise we will direct our efforts somewhere else with a better return.

In short, prices are an information system. I like to view the price mechanism as man's first rapid information system. In some sense the price mechanism was the first internet. Traders figured out exchange systems which allowed for people, living at great distances from one another, to transmit what their time and efforts were worth.

How would human exchange work without prices? It would not! Without a price mechanism how could you hire a plumber to snake out your toilets or go to a fast food restaurant to get a quick bite to eat. There would be no signals to direct people to engage in activities that other valued. We could serve ourselves and our immediate family and friends but this constituency would be insufficient to support any sort of real specialization. We would end up raising our own food and living in a subsistence economy.

One mystery is where do prices come from? Another way to view this is that prices are a measure of value. They are a measure of the value of what the producer puts into what is priced, but perhaps more importantly the striking price is what the consumer is willing to pay. No matter what what the inputs are a good or service is essentially worthless is there are no buyers.
It is all about supply and demand but this concept is actually meaningless. It is all about supply and demand at a given price. In other words, supply and demand has no meaning outside the context of price.

Two relatively recent schools have thought have dominated the perspective on price, the objective school derived in Germany in the mid-19th century and the subjective school in 19th century Austria. The objective school held that value (price) can be determined by measuring all the inputs that go into generating a good or service. The subjective school maintained that value was purely subjective and was determined solely on the basis of what someone was willing to pay. The objective school served as a philosophical basis for socialist and Marxist economic thought while the subjective concept served as the basis for free market capitalism.

What relevance do these concepts have now in the 21st century? They are as relevant now as they were over 100 years ago. Much of the controversy centering on health care reform comes back to these fundamental economic views.

More to come...

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