[Market Economy Guide] The Role of Market Prices

Prices contain countless pieces of information from the market

Without the “traffic signal” of price, both producers and consumers fall into confusion

■ Check Point

The law of supply and demand allows fragmented information scattered among individual economic actors to gather in the market, be combined, and be reflected in prices.

If someone tries to determine and control prices artificially, it can cause market distortions due to missing information and may even paralyze the economy.

What if there were no prices?

And when buying a car, you would look at the price range that fits your budget and ultimately choose the car at the most suitable price. In this process, price serves as a decisive factor in purchasing a car.

So what exactly determines price, and by what standard? Even cars all have different prices, and even the same car can be priced differently depending on the region where it is sold. The more one thinks about what standard lies behind price determination, the more curious it becomes.

Far more factors influence price determination than one might think. Countless kinds of information are needed: automobile sales volume, popular models, overseas car sales, fluctuations in steel prices, changes in transportation costs, changes in rubber prices, shifts in consumer demand, changes in trends, inventory levels, government policy, climate change, and more.

But no one can possess all of that information, and even if they did, they still could not determine a rational price on the basis of so much data. It is impossible for car manufacturers, consumers seeking to buy a car, or auto brokers to take all information into account. At most, they can grasp information in stages and identify prices by sector. For example, if climate change alters rubber output and causes rubber prices to fluctuate, that affects the production cost of automobiles. Car prices naturally respond flexibly to such changes in production costs. In this way, each piece of information is reflected in price step by step, and the final price is determined.

It leads to rational economic activity

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In fact, we cannot know all the information at every stage, nor do we need to. It is enough simply to observe price trends for the goods or stages that matter to us. That is because price is the result of reflecting all the information about goods and services traded in the market.

Therefore, automakers only need to consider the production costs required to make cars; they do not need to worry about the factors that determine prices in iron ore or rubber-producing regions. Consumers likewise only need to consider the price of the car. Rational decisions are possible simply by comparing the prices of the latest model and the previous model.

Not only with cars, but whenever we buy goods we need or like, or use services, we take price as an important standard. We compare prices with those of other products when deciding whether to buy, and we can roughly grasp the market rate. That is because price already contains and condenses the market’s countless pieces of information in an integrated way. Thus, by looking at price alone, we can sufficiently penetrate all the information in the market and engage in the most rational economic activity possible.

Price controls distort markets

The market reaches equilibrium autonomously and determines prices. As noted earlier, prices are determined by reflecting countless pieces of information that are difficult for us to know one by one. Then by what principle can prices be formed at the point where the satisfaction of market participants is highest?

Adam Smith identified the “invisible hand” as the main principle behind price formation. The invisible hand means the “natural order of the market,” that is, “the principle by which prices are naturally determined according to supply and demand.” In economics, this is explained as the “law of supply and demand.” “Demand” is the desire to buy a product, while “supply” is the intention or plan to sell a product.

The law of supply and demand allows fragmented information scattered among individual economic actors to gather in the market, be combined, and be reflected in prices. This is by no means something that people can artificially calculate or adjust. If someone tries to determine and control prices artificially, it can cause market distortions due to missing information and may even paralyze the economy. Is that not remarkable? With market prices alone, the most rational, efficient, and best outcomes are produced.

Sung-no Choi, President, Center for Free Enterprise (CFE)

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Original title: [시장경제 길라잡이] 시장가격의 역할

Author: Sung-no Choi

Date: 2018-10-08

Source: https://www.cfe.org/bbs/bbsDetail.php?cid=column&pn=16&idx=11141