Information and Prices

by Donald J. Boudreaux
About the Author
Modern economists excel at identifying theoretical reasons why markets might fail. While these theories may temper uncritical views of the market, it is important to note that markets do, in fact, work incredibly well. Indeed, markets work so thoroughly and quietly that their success too often goes unnoticed.

Consider that the number of different ways to arrange, even in a single dimension, a mere twenty items is far greater than the number of seconds in ten billion years. Now consider that the world contains trillions of different resources: my labor, iron ore, Hong Kong harbor, the stage at the Met, countless stands of pine trees, fertile Russian plains, orbiting satellites, automobile factories—the list is endless. The number of different ways to use, combine, and recombine these resources is unimaginably colossal.

And almost all of these ways are useless.

It would be a mistake, for example, to combine Arnold Schwarzenegger with medical equipment and have him perform brain surgery. Likewise, it would be a genuine shame to use the fruit of Chateau Petrus’s vines to make grape juice.

Only a tiny fraction of all the possible ways to allocate resources is useful. How can we discover these ways?

Random chance clearly will not work. Nor will central planning—which is really just a camouflaged method of relying on random chance. It is impossible for a central planning body even to survey the full set of possible resource arrangements, much less to rank these according to how well each will serve human purposes.

That citizens of modern market societies eat and bathe regularly; wear clean clothes; drive automobiles; fly to Rome, Italy, or Branson, Missouri, for holidays; and chat routinely on cell phones is powerful evidence that our economy is amazingly well arranged. An effective means must be at work to ensure that some of the relatively very few patterns of resource use that are beneficial are actually used (rather than any of the 99.9999999+ percent of resource-use patterns that would be either useless or calamitous).

The decentralized price system is that means. Critical to its functioning is the institution of private property with its associated duties and rights, including the duty to avoid physically harming and taking other people’s property, and the right to exchange property and its fruits at terms agreed on voluntarily.

Each person seeks to use every parcel of his property in ways that yield him maximum benefit, either by consuming it most effectively according to his own subjective judgment or by employing it most effectively (“profitably”) in production. Market prices are vital to making such decisions.

Vital Role of Prices

Market prices are vital because they condense, in as objective a form as possible, information on the value of alternative uses of each parcel of property. Nearly every parcel of property has alternative uses. For example, a plot of land can be used to site a pumpkin patch, a restaurant, a suite of physicians’ offices, or any of many other things.

If this plot of land is to be used beneficially rather than wastefully, those responsible for deciding how it will be used must be able to determine the likely worth of each possible alternative. Making such determinations requires reliable information. And market prices are a marvelously compact and reliable source of such information.

Offers on the land from potential buyers or renters combine with the current owner’s assessment of the value of the land to him to create a price for the land. Each potential user values the land by at least as much as he is willing to bid. The more intense the bidding, the more likely that each bid will reflect the maximum value each bidder places on the land. Of course, the market prices of goods or services that can be produced with the land are an especially important source of information exploited by potential users of the land to determine how much each will bid.

If the land’s current owner cannot use it in a way that promises him as much value as he can get by selling it, he will sell to the buyer offering the highest price. If a commercial developer purchases the land as a site for doctors’ offices, it is because this buyer observed that the rents for office space currently paid by physicians are sufficiently high to justify his purchase of the land, construction of the buildings, and purchase and assembly of all other inputs necessary to create a suite of medical offices.

The fact that the developer outbid pumpkin farmers, restaurateurs, and all other potential users of the land shows that this particular piece of land is now best used as a site for medical offices—or at least this is the best bet in an inherently uncertain world. Existing, actual prices guided him to this decision and guided others to avoid bidding more for the land than it is likely to be worth to each of them.

If consumers valued pumpkins with sufficiently greater intensity, the market price of pumpkins would have been high enough to inform pumpkin farmers that it was worthwhile to outbid any other potential user. Similarly, if, in the future, consumers come to value pumpkins more highly—or if, say, a remarkable new cure-all pill is invented that significantly reduces people’s demand for physician services—pumpkin farmers might then find it worthwhile to buy the land, raze the medical offices, and plant pumpkins.

Equilibrium Prices Unnecessary

Nothing about market prices requires that they be “correct” in the sense of being the prices that would exist in general competitive equilibrium. All that is required for the best achievable economic outcomes is that actual prices give producers and consumers sufficiently reliable information and incentives to help them to coordinate their actions—to use resources in ways that are mutually beneficial relative to all other possible ways currently within human purview.

Mistakes will be made and changes will occur that continually reveal some uses of resources to be less desirable than other perceived possible uses. Producers and consumers continually respond to this information by adjusting their decisions at the margin. Prices change accordingly. Each adjustment tends to improve resource use. Such decentralized, local adjustments that improve resource use are the best that humans can achieve. Comparing this ongoing market process of adjustment, mutual accommodation, and improvement in resource use to a hypothetical “perfect” equilibrium state of allocation only courts misunderstanding. The fact that real-world markets do not achieve all imaginable gains and eradicate all vestiges of human ignorance and error is simply irrelevant, for no set of actual institutions can achieve such a fantastical outcome.

Of course, for this process to work, prices must reflect the relevant costs and benefits. If people do not take account of substantial costs of their actions, they will act in inappropriate ways. They will either engage in too much of an action (if the ignored effects are costs imposed on third parties) or too little of it (if the ignored effects are benefits enjoyed by third parties). The well-recognized existence of externalities creates, at least in theory, a situation that can be remedied by wise government regulation, taxation, or subsidization.

Even in the face of significant externalities, however, one method of government intervention remains especially suspect—namely, price controls. Any arbitrary floors or ceilings placed by government on prices will either prevent better prices from emerging or—if the market is infected by significant externalities—mask the problems that can be solved only by changing the underlying demand or supply conditions (see, e.g., rent control).

By far the most important way to ensure that the forces of demand and supply result in prices that encourage useful coordination of economic plans is to keep property private, divisible, and transferable. The actual result of this ongoing series of decentralized resource-use decisions guided by actual market prices is a commercial economy of enormous productivity and prosperity for nearly every human touched by it.


About the Author

Donald J. Boudreaux is chairman of the economics department at George Mason University in Fairfax, Virginia. He was previously president of the Foundation for Economic Education. He blogs with Russell Roberts at http://cafehayek.typepad.com/.


Further Reading

Alchian, Armen A. “Property Rights.” In this volume, below, and online at: http://www.econlib.org/library/Enc/PropertyRights.html.
Arrow, Kenneth J. “Toward a Theory of Price Adjustment.” In Moses Abramovitz, ed., The Allocation of Economic Resources. Stanford: Stanford University Press, 1959.
Coase, Ronald H. “The Marginal Cost Controversy.” In Ronald H. Coase, ed., The Firm, the Market, and the Law. Chicago: University of Chicago Press, 1988.
Hayek, F. A. “The Use of Knowledge in Society.” Available online at: http://www.econlib.org/library/Essays/hykKnw1.html. In Hayek, Individualism and Economic Order. Chicago: University of Chicago Press, 1948.
Kirzner, Israel M. How Markets Work: Disequilibrium, Entrepreneurship, and Discovery. New Delhi: Centre for Civil Society, 1997.
Machovec, Frank M. Perfect Competition and the Transformation of Economics. London: Routledge, 1995.
Read, Leonard E. “I, Pencil.” The Freeman. Reprinted in Leonard E. Read, Anything Thats Peaceful: The Case for the Free Market. Irvington-on-Hudson, N.Y.: Foundation for Economic Education, 1998. Online at: http://www.econlib.org/library/Essays/rdPncl1.html.
Schumpeter, Joseph A. “Can Capitalism Survive?” In Schumpeter, Capitalism, Socialism, and Democracy. New York: Harper and Brothers, 1942.
Stigler, George J. “Competition.” In Stigler, The Organization of Industry. Homewood, Ill.: Irwin, 1968.

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