Money prices are a truly remarkable phenomenon. They drive market decisionmaking, and help ensure that consumers get what they want, when they want it, and in the quantities they want. Even more important, it is the ability of prices to be flexible in response to changes, to move up and down quickly in response to demand or supply changes, that almost single-handedly prevents shortages and surpluses from occurring.
Though we often pay more attention to rising prices than to falling ones, price flexibility (both directions) is absolutely essential to the process of coordinating people’s plans across the economy. Why? Trade is a two-way street, and it is coordinating. Money price information is key to helping make that so.
What is the nature of this all-important price? As consumers we all want prices to be zero, though scarcity makes that impossible. As suppliers we want payments (the price that others pay for our labor, goods or resources) to be virtually unlimited. Through the process of exchange, buyers and sellers arrive at a mutually agreeable rate of exchange. This is what we are calling price, especially when we express it in terms of dollars and cents. To really understand why price flexibility is important, though, it is useful to understand price in a more primitive form—exchange rates of goods for other goods, a barter economy.
Take an example: Let’s say I produce more economics lectures than I can personally use, but less breakfast cereal or automotive services than I would like. I decide to trade away some of those lectures to others, presumably those who cannot so readily produce them, to try to get what I want instead. Until I accomplish the trade, I personally have an excess supply of economics lectures, but a deficit, or excess demand, of a whole list of other goods.
Let’s also assume that I would like to have some Cheerios for breakfast, and would really like to drive a Volkswagen car. I could try to trade economics lectures directly to General Mills or Volkswagen if these are my breakfast and driving choices.
The difficulties are immediately apparent. I, for one, want breakfast this morning. To try to accomplish that, I must communicate with General Mills, convince them of the value of my lectures, negotiate an exchange rate between myself and the company, and figure out a delivery mode and schedule for lectures vs. cereal. Let’s say it could be done. Even if I could set myself up for an entire year of Cheerios at some lectures-to-Cheerios exchange rate—certainly better than attempting this every day—I have expended considerable transactions costs in the process. And if I decide I’d like to try some Quaker Oats for breakfast one morning, or eggs, or herring or potato chips? I’ve got to begin brand-new negotiations.
Indirect exchange often makes this double coincidence of wants I have been describing unnecessary, but barter is incredibly cumbersome, and every ‘price’ is a ratio of a quantity of one good to be exchanged for a quantity of another good (as in: the number of econ lectures required to obtain a specific quantity of Cheerios). Think of doing this each day, and even one breakfast becomes daunting.
Enter money, and money prices. Once people in society recognize a unique good in the economy that can readily be exchanged away for the things we ultimately want, prices will be quoted in that single item—salt, gold, shells, all have historical precedent. That item becomes the money. This is a good, because it streamlines every transaction.
Money prices, then, represent an exchange ratio between goods. The money price might be thought of as a unique intermediary yardstick. We can hold it up to measure the relative value of goods in a market, and it will apply more or less accurately to all parties about to enter into exchanges. We expect in this situation that as values change, price will have to change too. In a very basic sense, money prices reflect the underlying reality that is so obvious in barter: it is goods and services that are actually being traded.
While the price-yardstick analogy is imperfect, it does indicate that prices cannot be arbitrarily changed by parties outside of the exchange, and still be expected to reflect exchange values or coordinate the plans of buyers and sellers. That’s why regulated prices, whether minimum wage laws, anti-price-gouging laws (maximum-price laws), or others, disrupt plans of suppliers and consumers.
In a static world, we wouldn’t need flexibility in market prices. But weather, fashion, food poisioning scares, and coutless other things are dynamic realities that demand flexibility. Flexible prices can and do capture those dynamics by adjusting as realities dictate. Our best pricing strategy, if we want the smoothest possible coordination of plans in the economy? Allow the Invisible Hand to direct economic traffic. When prices are flexible, traffic jams tend to disappear on this two-way street.