The Science of Everything Podcast - Episode 12: The Price System

Episode Date: January 6, 2011

An examination of how the price system works, including an introduction to supply and demand theory, and the concepts of clearing the market and surplus maximisation. We also look at how the price system promotes efficiency helps to regulate economic activity. Also includes a discussion of how prices store and communicate economic information.

This is the Science of Everything podcast, episode 13. I'm your host, James Fodor. In this episode, I'm going to look at the price system, specifically how supply and demand can act in concert to achieve a price that clears the market, maximize a surplus, achieves efficiencies in production and consumption, and just generally regulate economic activity in such a ways to achieve a desirable, efficient, useful outcome, all without any central planner and how, we'll look at how this emerges spontaneously from voluntary individual decisions, which is quite a remarkable feat.

So, before I start, I'd just like to say that the things I'm going to talk about here are simplifications for the purpose of emphasizing how the free market can work under normal conditions, I would say. There are certainly market failures, or times when the free market doesn't work. Examples include externalities and public goods, imperfect information and so on, and a large proportion of economic literature seeks to examine these market failures and how they can be rectified or how they can't be rectified. But for the most part, there is general agreement amongst economists that the market generally works pretty well to organize production and to regulate the economy. And so generally the things I'm going to be saying in this episode apply most of the time to most areas.

And so with that caveat, let us begin. So first of all, I want to explain what I think is the economic problem. In other words, what are economics, what is economics about, what is the free market for? Well, the fundamental idea behind economics is that of scarcity, the inability to have as much as we want of, well, pretty much anything. The idea is that no matter how much we get of something, or how much better things become, we still want more. So, you know, life expectancy has increased by many decades over the past couple hundred years, but we still want to live longer. Communications have become much easier, and yet we still want faster modems and more broadband hookups and other things like that.

Cars are getting more fuel-efficient and more comfortable all the time, but we still want the more faster, more comfortable, more fuel-efficient, and of course cheaper. Houses are much more comfortable and larger than they used to be, we used to want them bigger and cheaper, and so on. So no matter how much of anything we get, there's always more to be had. We can always use more. This is a basically inevitable, I guess, outcome of the human condition. And there's a good quote that I'd like to read from Adam Smith, who was kind of the founder of the discipline of economics.

In his book, The Wealth of Nations, he said, quote, there is scarce, perhaps, a single instant in which a man is so perfectly and completely satisfied with his situation as to be without any wish of alteration or improvement of any kind, end quote. I think that sums up the basic idea of scarcity. No matter how good things get, they can always be better, and we always want them to be better.

And so the question is, then, how do we deal with a world of scarcity, when there is never enough of anything? And that is the central concern of economics and of the economic system. The economic system, which is the method of production and exchange and trade and all that sort of stuff

that goes on in human society, is sort of humanity's responsibility, response to this problem of scarcity. How do we make the best use of the resources that we have? And economics is the discipline that studies the economic system and how people respond to these sorts of incentives and to these sorts of issues. So as you can imagine, the problem of how do we make the most out of the scarce resources that we have is quite a profound one, because there are literally there are billions of people in the world, each of whom have unique skills, each of whom own unique types of capital goods and other equipment and possessions that can be used for production.

Also, one can add all the different passes of land and other natural resources that exist. And these can all be combined, labour, goods and land in a myriad, essentially infinite number of different ways to produce different things. Most of these possible methods of production would be fairly ridiculous, but even taking the reasonable portions like how many resources do we put towards making coal, mining coal versus producing steel versus producing computer games versus cutting hair. And where do we do all this? Who does what? What methods of production do we use?

These are the questions of economics. And there are so many different possibilities, as I said, effectively infinite number of ways that we can produce goods and what we can produce. There has to be some way of picking which one we use, obviously. And that's what the free market does. The amazing thing about the free market is that without, any central planner, without any overarching committee deciding things or anything like that, a highly efficient, not always the absolute most efficient, but generally a highly efficient

outcome is reached in terms of how goods are used to produce, sorry, how inputs and other factors of production are used to produce, to produce goods and services, how we get the most out of our scarce resources. So that's what we're trying to explain. How does that happen? How can that possibly happen with people just acting in their own self-interest, which is what the free market is, people just sort of doing what they want. That's what we're trying to explain here. Now, the first thing that we need to understand before we can explain that is the concept of supply and demand, which you have probably heard of before. This is the bread and butter of economic theory, if you like. The core concept of supply and demand is that the size of the demand for a particular

good. Let's call them widgets, which is just a generic name for a good. So the total amount of demand for widgets and the total amount of supply of widgets interact with each other to determine the price of widgets and the total amount of widgets that are sold or that are traded. So to explain this concept, economists frequently use a graph of two straight lines that intersect each other. You may have seen one of these graphs. Just basically think of a standard X, Y, access graph, and then onto that superimpose a big cross, like an X, with one downward sloping line and one upward sloping line. The downward sloping line is called the demand curve,

and it represents all the different valuations that consumers place upon the good, or the widget in this case. And the upward sloping curve is the supplier curve, and it represents the valuations that suppliers, or people selling the good place upon the goods. And so the X and Y axis, in this case, represent price and quantity. So the X axis represents the quantity of goods that are sold or that are traded in the market. Y axis represents the price at which the goods are traded.

And so you can think of the demand curve, that's the one that slopes down, as starting at a very high price and low quantity, and then going down to low price and high quantity. And that makes sense, because you can think about it this way. Some people want widgets a lot. They're willing to pay a lot of money for them, but they're only a small number of people who want widgets that much. And so you plot a point on the graph of high-price, low-quality.

Equivalently, if the price of widgets fell to really low levels, people would want heaps of them. So the basic concept of that is, that's the law of demand. The higher the price that people must pay for a good, the less of it they will want. And effectively the same idea works in reverse when looking at supply. the supply curve slopes upwards. So if the price of a widget is low, only a few people will be willing to sell them. Those will be people maybe who already have heaps of widgets or who can make them really cheaply or whatever. Equivalently, if the price of widgets goes up really high, lots of people will be willing to sell them

because they can get more in exchange for the same number of widgets. And so what economists are really interested in is the point of equilibrium where the two curves, the two lines, demand curve and supply curve intersect each other. And this is when the quantity of... the quantity of widgets supplied is equal to each other. This is called the market equilibrium, and at that market equilibrium, we read off the, at that point on the graph, we read off the price and the quantity traded, and that will tell us the equilibrium where the market equilibrium occurs.

And the reason it has to occur where the two curves intersect is sort of fairly intuitive, because for every widget that is sold, someone has to be buying that widget. So the quantity sold and the quantity sold on the quantity bought, or the quantity demanded and the quantity supplied have to be the same. If there are more people trying to sell than trying to buy a widget, let's say, the price will be driven down because the sellers of the widgets will be competing with each other to try and sell the widget. So some people will be willing to accept a lower price in order to sell their widget. And so in the act of competing against each other to sell the widget, the price of the widget will be driven down.

Equivalently, if demand for widgets exceeds the supply, then different buyers, people who want the widgets, will be beating against each other to try and obtain one of the limited supply of widgets, and because they'll be bidding against each other, they'll try and pay more than the other person to try and get the limited number of widgets, and so the price will be bid up.

Now, the great thing about the concept of supply and demand is the concept of clearing the market, is that in a free market, or at least in a reasonably competitive market, when you don't have significant market failures, as I mentioned before, the market will always clear, or the quantity demanded and the quantity supplied will always be brought into equilibrium with each other. And this happens because of the exact mechanisms that I explained before, if there's excess supply, buys bid against each other,

and the price is driven up until a point is reached at which there is no longer excess. sorry, if there's excess demand, the price is driven up until the level is reached at which point there is no excess demand, and vice versa, if there's excess supply. So the equilibrium price will always exactly balance out supply and demand so that there's no excess demand and no excess supply, and the market is then said to be cleared. Everyone can buy exactly how much they want, everyone sells exactly how much they want at the given market price. Of course, if the price was lower or higher, people would want to buy and sell different amounts, but that's sort of not directly relevant to the equilibrium condition where price just nicely balances out demand and supply.

Now, this concept of supply and demand and market equilibrium works very well in theory. It also has been tested in control and experimental settings using pretend money or even real money and various setups, and it really works. Markets do clear under a whole bunch of different conditions. Contrary to what some may say, these assumptions don't. don't only just work if you meet a whole big long list of assumptions like having an infant number of buyers and sellers and having perfect information and zero transaction costs and all that. You may not understand what I'm referring to, if so, don't worry. But if you do,

those things help and they're sort of, they are related to the economic theory behind these models, but they're not really necessary for the kind of processes that I'm describing to happen for the most part. So, you know, markets, in the real world, markets may not clear perfectly, but most the time clear pretty well and work pretty well. So why is this concept of supply and demand and market clearing so interesting? Even if it does happen, so what? Well, the interesting thing is that it greatly increases the efficiency of how we use our goods. Just think about it. Under a market clearing system, everyone is always able to buy however much of any good they want at any time. pretty much, more or less.

So you think about it, when you go to the shops, and you want to buy, I don't know, milk, in almost all circumstances the milk is there waiting for you to buy. It's just sitting there. Equivalently, supplies of milk, gently, and most circumstances don't have enormous stockpiles of milk that they can't do anything with. Of course, they do keep stockpiles of these things, you know,

to be ready to use on the shelves, but they're not continually accumulating more and more. nothing they can do with them. So the point is that the price adjusts so that people can get as much as they want and people can get rid of what they have. And so supply and demand are brought into balance. This is very important for having an effective efficient economy because if we just had, you know, heaps and heaps of steel bolts and hardly any computers or whatever else, that wouldn't be very efficient. The free market insurers that we have just basically just as much of every as we want, relative to everything else. Of course, we'd want more of everything if possible,

but we wouldn't want a thousand times as many computers and half as many cars, for example. The free market ensures that we kind of have a balance between all these different things. So we don't have massive hordes inventories of some things and huge shortages of other things. And how does that happen? Because the price adjusts. But there's even more to it behind that, because actually, it's not just that we can have, that we have sort of the right amounts of everything is that if you actually have a perfectly competitive market, and this is where this assumption of perfect competition does become important, I won't go into explaining what that is now, but it's kind of like you have lots of different buyers and sellers,

and it's easy to trade and stuff like that. But if you make these assumptions, then these assumptions do hold pretty well most of the time in many markets, not all of them, but wheat markets like the class example, you know, lots of buyers and sellers, the product's the same, it's easy to trade and so on. Anyway, if you make these assumptions, you can actually prove, sort of mathematically, informally, that the total surplus that all buyers and sellers gain out of trading is maximized at the free market equilibrium. The surplus is defined as the total value that someone places upon the good minus the amount of money that they have to pay for it,

or minus the surplus that they place upon the amount of money that they have to pay for it. So, for example, suppose that you would be willing to pay $50 for a CD. That was your maximum valuation for it. If you paid $50 for it, you would be just indifferent between paying the $50 and not paying it. So that would be your valuation of the CD. But suppose you only had to pay $20 for it. In that case, your consumer surplus, it's called consumer surplus because you're a consumer, in this case you're buying the thing, would be $30, $30, $50 minus $20.

So the total value you place on it minus the amount you had to pay for it. That's your consumer surplus, $30. The reason people engage in trades is to gain surplus effectively. Because just think about it, you wouldn't buy things if you were always indifferent between buying them or not buying them. Or in an even more extreme case, you wouldn't pay $70 something if you only actually place $50 of value on it. That would just be a complete waste.

You'd get negative surplus from that. So people engage in trades in order to gain surplus in order to get things that they want more in exchange for something that they want less. Now, as I said before, coming back to the market equilibrium, it can be shown formally that at the free market equilibrium, where supply and demand are balanced, total surplus, including that of suppliers and demanders, or buyers and sellers, is maximized.

Now, obviously, if the price goes down, then consumer surplus increases, because the same number of consumers are still all getting the good, but they're all paying less for it. and so they're all happy because their surplus goes up. But producer surplus goes down. And also, the quantity traded of goods goes down as well. And it's kind of a bit hard to explain how all that works without a graph,

but you'll just have to take my word for that. There's the trade-off between consumer surplus and producer surplus, and the maximum point is always reached at the market equilibrium when supply and demand are perfectly balanced. And so that's when, if you like, the total amount of surplus, the total social benefit of the exchanges, is maximized. And that's another great thing about the free market, how supply and demand balance each other out, clear the market, you get to the equilibrium where surplus is maximized.

And that's pretty cool. But there are more advantages of the free market prices when I like to discuss now. Some more subtle ideas that you may not have heard of before if you've heard of supply and demand. Okay, there's this concept of the uniformity of prices. And this is effectively the idea that the price of a good, so the same good, we'll talk about widgets again, the price of widgets tends to be uniformed throughout the entire world and throughout all, throughout different times, except for transportation costs and costs of storage. So suppose that the widget can only be produced in, I don't know, one particular region of Italy. The uniformity of prices theory would say that the widget should cost the same at all points in the world. It should in fact cost,

however much it costs to manufacture it, plus a little bit of profit. But in addition to that would be however much it costs to transport it to wherever you are. But let's just ignore transportation costs for the moment because they kind of complicate things, but transportation costs aside, goods should the same good, or a widget, should cost the same amount in all parts of the world. And why should that be? Or, well, just think about it. Suppose that widgets were substantially cheaper in the USA compared to Italy. Well, and just assume away transportation costs. Well, then people would buy widgets in Italy and, sorry, in the USA where they're cheap and sell them in Italy where widgets are expensive and they'd make money.

And so people would, and this is called arbitrage or sometimes speculation, although speculation can be somewhat different, but anyway. And this is what happens in the real world. People will buy things where they are cheap, sell them where they're expensive and make money. But the thing is, as people do that, the supply of the widget in the place where it is cheap goes down, and when that happens, the price goes up. Equivalently, the supply of the good increases, in the place where it is expensive, and so the price goes down. And this trend continues until the price of the good is the same in both areas. Once again, excluding transportation costs.

And the same thing happens across time. Suppose that we were expecting a drought next year, and we wouldn't be able to have a wheat crop. So what would happen? Well, people would be expecting there'd be to be very little wheat next year, and if there's a low supply, and presumably the demand for wheat is the same as it ever was, low supply, relatively high demand, that means a high price.

So if people are expecting a high price of wheat next year, what are they going to do? They're going to buy the wheat this year and store it and sell it next year. And this is another form of speculation or arbitrage. Of course, you have to subtract the costs of the storage, but just neglecting the cost of storage for the moment, people will keep doing that. They'll keep just buying wheat in the present and storing it to sell in the future

until the price in the present is expected to be the same as the price in the future. Once again, adjusting in the real world, you have to adjust for storage costs and also interest payments on your capital and stuff like that. But the basic principle is the same. You're not going to have substantial massive asymmetries in prices between the future and the present, as long as what happens in the future is to be expected. Obviously, if it's an unexpected event, it doesn't quite work. but for expected future events, prices will equalize, and as I said before, prices also equalize across space.

Now, why is this important? Why do we care about this? Uniformity of prices principle. The reason we care is because it helps to ensure that resources are used as effectively as possible. For example, if we have heaps of widgets in the USA, but hardly any in Italy, it probably means that moving a widget from the USA to Italy would be beneficial. because of the principle of decreasing marginal utility. Basically, the more you have of something, the less beneficial each additional unit is to you. This is what marginal means.

Marginal anything is a very important concept of entomics. It just means the effect of one additional unit of something at the margin. That's what that means. So think about it like this way. If you have one ice cream, that tastes really good. That's a great ice cream. If you have two, it's pretty good. But by the time you got your fifth ice cream,

you're kind of sick of it. So you don't enjoy your fifth ice cream nearly as much as your first ice cream. That doesn't just apply to consumer goods. It applies to capital goods as well, or goods that are used to make other goods. So think about if you're running a business and you buy your first computer, that's going to substantially increase the efficiency of your business. Now you can do things on the computer. You could type instead of having to print out everything or having to work on paper, etc., etc.

You can send emails. When you buy a second computer, well, that might help. Maybe your secretary can now use a computer as well. But by the time, you know, you get three or four computers. doesn't help as much. Maybe there's some use you could put to it, so it's not completely useless, but it's not as good as the first one. This principle of decreasing marginal utility is pretty much ubiquitous. It applies almost everywhere. And because of this, if you have, say, heaps of widgets in one place, but hardly any widgets in another place, if you take a widget

from the place where there are heaps of them, say the US, if you take a widget from the US and move it to Italy, it'll be more useful in Italy than it was in the US. And so that will increase the overall output or overall benefit that we get from the same resources. The same thing occurs across time. I mean, suppose that we had heaps of wheat this year, but we're expecting to have hardly any wheat next year because of a crop failure. This year we might have so much wheat that the price of it is so low that people are using it to feed their cattle or to make bread to feed birds

and other relatively unimportant uses, whereas next year there'll be so little wheat around that people will be using it to make bread just to survive, to feed their children. The uniformity of prices principle tells us that people will buy bread now, save it for later, and sell it in the future when it's going to be more expensive, and thereby, or sorry, wheat, not bread, and thereby moving the wheat to be used in a time where it will have greater use, greater utility, because there's less of it.

And so this principle of the uniformity of prices greatly helps to ensure that we can, get the most out of the scarce resources that we have. And so, and as I described before, it happens naturally in free market. People just naturally pursuing their self-interest to make money will buy, buy low and sell high, and help to even out prices across space and time. And in doing so, they help to achieve this end unintentionally, but they still do, of maximizing efficiency of use of goods. Now, speaking of efficiency, I'd like to move on to talking about production and consumption efficiency and how the free market ops to achieve these. I've already sort of hinted at it with maximizing consumer and producer surplus and the uniformity

of prices, but I'd like to just address it more explicitly. Production efficiency refers to the how we use our resources, raw materials, labor, capital goods, stuff like that, how we use all those inputs to create outputs. So for example, you could imagine a good example is Henry Ford. he developed a new procedure, you know, the moving production line, to make automobiles from effectively the same inputs, you know, basically the same way, but basically similar sorts of tools and other things, but he combined them in a different way to make cars more efficiently.

He got more cars out of the same inputs. He just sort of used them in a different way. He mixed them around differently. That's production efficiency. You can do something efficiently, or you can do it, not very efficiently. you know, if you're going, if you're driving to work, you can take the long way or the short way. You still get to the same place, but one's much more efficient in terms of time and fuel, one's less efficient. The same concept applies in economics.

There are, you know, literally an infinite number of ways you can make goods, even simple things like pencils or shoes or whatever. You can make them many different ways, but some will require more resources, more time, more energy, more labor, more coal, whatever. And some will require less. of course we want the most efficient methods to be used we want to try and maximise production efficiency so that we can get more out of less that's the production side

that's the producing there's also consumption efficiency and that is with the goods that we already have with the consumer goods that we already have by the way consumer goods are just goods that you consume like food clothes and stuff like that as opposed to producer goods

which are goods used to make other goods like machines and bulldozers and stuff like that. Consumption efficiency says it, well, given the consumer goods that we have, never mind how they were produced, just given the bunch of stuff that we have, how can we allocate them between people so as to maximize efficiency? So, for example, suppose that you have four ice creams. How do you allocate them?

And two people. Do you give two to each? But suppose that one of the people really doesn't like ice creams. and only likes them a little bit, and they would only want one ice cream, and that it would actually be, whereas the other person likes ice creams a lot, so they like lots of ice creams. So maybe it would be better to give one ice cream to one person and three ice creams to the other person.

But then maybe suppose you also have, I don't know, hamburgers, and maybe the person who doesn't like ice creams really likes hamburgers and vice versa. So instead of just giving two hamburgers and two ice creams to each of the people, you give three hamburgers to one and one and one hamburger to the other, and three ice creams to one and one hamburger to the other. You can see that that's using the same bundle of consumption goods, but it's allocating in a different way to increase efficiency.

So both of the consumers now are happier than they were before, if they'd only had two hamburgers and two ice creams each of them. They're both better off, but we've used the same number of goods. That's what consumption efficiency refers to. And it's a fairly intuitive concept because not everyone spends their money on the same stuff. And so if you just gave everyone exactly the same everything, same clothes, same amount of food, same car, whatever, people would be equal, but they wouldn't be equally happy because some people would prefer more of one thing, less of another thing, etc. That's consumption

efficiency, and we want to try and maximize that as well. Now, how does the free market help to achieve production and consumption efficiency? Well, it does so because in a free market, let's look at production efficiency first. In a free market, producers are forced to take into account the impairment that they do to people making other things or to other potential uses of the resources. So, for example, if a businessman wants to make cars, let's say, they need to use steel. But as they are trying to buy the steel or as they are using the steel, they must take into account, well, they have to take into account how much the steel costs, obviously. But incorporated into the price of the steel is information about other potential.

uses, or existing uses and potential uses of that steel. So, for example, people want steel to build buildings or to make toys or to make machines, all sorts of things that are used for steel. Now, the more important are those other uses of steel, the higher the amounts that they are willing to pay for the steel. And so, if you're like, you can think of it as there's the carmaker and the shipbuilder. the carmaker and the shipbuilder are both competing for the same amount, limited amount of steel. If consumers say cars are more important than boats, relatively speaking,

then they are willing to pay more for cars. And so the car producer is then willing to pay more for the steel than the shipbuilder is. And so what happens is that the car producer takes a relatively larger portion of the steel than the boat producer. and this happens for everything in the market, not just there obviously are literally thousands of different goods and they can produce many different ways. So when someone is looking for the production method to use, they have to take into account the impairment that they would make

on production of any other good that could be made. So they'll look for the cheapest possible alternative. You know, maybe for another example, maybe you can produce computers using a few machines and lots and lots of labor or lots of machines and only a little bit of labour. Now, which one should we use? Well, we should use whichever technique impairs the production of other stuff the least.

So suppose using the high-labour, low-tech solution, just pretend the only other thing we're making this economy is socks, just to keep it simple. Suppose using the high-tech, sorry, the low-tech, high-labour technique would be able to make a thousand socks. But then suppose using the high-tech low-labour technique, we could make 2,000 socks for the same non-tech.

number of computers. You get the same number of computers in either case. In this case, clearly the second alternative, the high-tech and low-labour, would be better because we get the same amount of computers, but more SOX. In this case, the computer producer would be driven to choose that option, effectively because the price of labour would be bid up by the producer of SOX. And so they'd see, ah, well, if I adopt this high-labour-low-tech solution and it would have given me the same number of computers, but labour would be too expensive. So I'll use this low-labour, high-tech solution, which will be cheaper. So by virtue of changes in the prices of inputs, all the different activities in the economy have to take into account the impairments that they make on the production of other things, or on the satisfaction of

alternative wants. And so in this way, we get optimum use of resources. Now, if this sounds a bit confusing, like you see how it can work in two-igs, in an economy with two goods, but how does that work in economy with a thousand goods? I mean, it's not really possible. to trace out all of the, you know, intricate mechanisms, and that's kind of what's great about the free market is that you don't have to do that. No one has to plan any of this, or sit down and work it all out. It just happens spontaneously, and it all happens at the margin. So, you know, if the car manufacturer is producing too many cars, he'll find that he's not able to sell all of his cars at the given price, and if he raises his price, no one wants to pay that much. So what

he has to do is stop making as many cars. And when he does so, He'll reduce the demand for steel, and thereby maybe the price of steel will come down a bit, and so steel will be freed up to use in the production of something else, and maybe that's something else consumers will want more than the cars. And so in this way, as each industry or each business adjusts its production plans at the margins and adjusts its different methods of production at the margins, to use more, labor, less labor, more of this, less of that, in response to changing prices, as they adjust this production,

methods of production, essentially coordinating themselves with all the other producers in the economy, and in doing so, helping to achieve production efficiency. And now, consumption efficiency happens in a very similar way. And it's a little bit easy to understand in this case, because when you want to purchase anything, you are forced to take into consideration the needs and desires of others. Now, the beauty of this is that this happens regardless of whether you're selfish or or not. So, you know, we could just ask everyone,

suppose we just opened up a supermarket and say, well, just take everything you need, take whatever you need, but remember other people need stuff as well, so don't be too greedy. Well, we could do that, but it probably wouldn't work too well. There'd be a huge incentive for people just to take way too much of some stuff and not worry

too much about what others want. Or even if they were worrying about what others want, they may not really know what others want, and so they take too much of some things and none of some other things that people didn't want. What prices do, though, is they provide information to each consumer about how much other people want that particular good. And they force you to incorporate that information into your decision-making process. So obviously, if lots of other people want something, the price of it will go up.

And so you will be forced either to spend less money on something else, so you have to withdraw consumption from something else and put more money into buying this one thing. Let's call it some vintage wine. Suppose lots of people want this vintage wine, and the price of it's really high. that forces you to keep your consumption of it fairly low. And so to make more of it available for others. Alternatively, you could keep buying this amount,

but in order to do so, you'd have to pay more money for it, in which case you have to reduce your consumption of other stuff. So you're saying, well, I really want this wine, but I know lots of other people want it too, so what I'm going to do is give up consumption of all this other stuff in order to keep the consumption of this wine. Alternatively, if there are some things that are very cheap, because lots of people don't want them,

you might say, well, I don't actually mind. maybe there's, I don't know, a flavor of cheese that's really disgusting and hardly anyone likes it, but it's really easy to make. Maybe say, well, I don't like the flavor of cheese that much. No one does, but I don't mind it too much. And so I'm willing to pay, I'm willing to save money, buying this flavor of cheese over another flavor of cheese, and sort of take the hit for the team by eating the not-so-nice cheese, but in return, what I get is extra money save that I can consume on something else.

and the great thing is that you self-select to do that. So someone else may have, you know, someone else could have done the same thing, but maybe they really, really hate that flavor of cheese. And so even if they did get extra money spent on something else, they wouldn't want to do it. But you, no, you don't mind so much. So you're willing to have the not-so-nice cheese and get something else in return. And it's in this kind of way that all the consumers using prices,

the relative prices of different goods, take into consideration the preferences and desires of other people when making their consumption choices. And in this way, consumption efficiency is achieved. Once again, actually proving that consumption and production efficiency are actually completely achieved in a free market setting requires a whole bunch of maths and graphs and other complicated stuff. So I can't really do it here.

But hopefully I've given you an outline that you can kind of understand how it works, how production and consumption are coordinated amongst individuals. And so one thing, what I'd like to finish on is this concept of prices as information. And I've sort of mentioned this before, that prices convey information. What do I really mean by that? Well, prices are really important for two reasons. One is that they just permit meaningful comparisons. So, for example, suppose you didn't have any money, you didn't have any prices.

How would you compare a table to a chicken or to a car? I mean, is a table worth two cars, or is it worth half a car? Is it worth three chickens or four chickens? I mean, you could do that, but then you'd have to say, well, this table is worth half a car, four chickens, 19 bags of sugar, three books, you'd have to list the prices of thousands of different goods. There'd just be no way you could do that. As a business, how would you decide if you'd made a profit or a loss?

I mean, let's say that you'd sold 100 chickens and taken in, I don't know, 50 tables and two cars. Or is that a profit or a loss? How do you know? There's no meaningful way of making comparisons. And suppose that you could buy a pound of milk for six eggs, or half a loaf of bread? How do you know which one is a better price? Money and prices is what allows us to express the value of all different goods in the same unit, in dollars,

or in the case of some countries, other countries use the euro or the yen or whatever. It doesn't matter, as long as you have that common unit of currency to express the price of everything in, and that then permits calculations of profit and loss, relative efficiencies of using this method or that method of production, relative costs of consuming this versus that, etc. So that is just vital in order for a complex economy to function, to have that sort of method of accounting and keeping track of things. That's one way prices convey information, but that's not the only way. Another way they convey information is that they convey information about the value of alternative uses of each input that was used to make the good. So the more expensive something is, the more expensive, say, a bottle of wine, is that tells you that either lots of other people want that.

good, and or that the resources that were used to produce that bottle of wine had very high alternative uses if they were to be used for something else. So suppose the land of the vineyard that grew the wine, if it hadn't been used as a vineyard, could have been used to raise cattle and produce beef that then could have been sold for a lot of money and that people would have really valued that beef. If that's the case, then the wine grow is going to have to be able to raise more money from the wine that they sell than the beef producer would be able to, because otherwise wine grower would convert to growing beef, or that they'd be bought out by the beef grower because they'd be able to make more money, they'd be able to offer them a really high price.

So anyway, the point of the, the point is that the higher cost of the wine is conveying the information to you that the alternative uses of the stuff that's making the wine are highly valued by other people. And that, in turn, leads you to take action that hopefully minimizes the, well, not hopefully, that minimizes the impact you're having upon that other consumption. So suppose you see the price of this wine is just getting ridiculously high. Maybe it's because the land that the vineyard is on would be really good for grazing cattle, and people really want meat for some reason.

The value of meat's gone up a lot, people really want it. And so the alternative value of this land that the vineyard is on is going, going up really high, and therefore the price of the wine is going up really high. You see that, you see that the information then comes to you in the price of the wine. Otherwise, how on earth would you know that you should stop drinking this wine because other people want the land on which the wine is growing to be used to produce beef, to grow beef to make cattle, to raise cattle to make beef? How would you know that? There's no way you could know that. And that's a relatively simple example. The economy obviously gets ridiculously more complicated than that.

you know, people must provide catering services to people who cut down trees that are then processed to make pencils that are used to carry out, to write down the production information for making something else. You know, production can be very, very roundabout. There's just no way that you could possibly know all this stuff. But prices provide that information in one very convenient and transparent number. And also then you can compare that information from different sources. So let's see, suppose you wanted wine, but the wine from this particular place is getting really expensive.

You look for somewhere else that sells wine and try and find one that's pretty cheap. If you do, that's telling you that, well, it might tell you that the wine tastes like crap, but suppose that it didn't, it would be telling you that, of course it might tell you that the wine doesn't taste very nice, but supposing that the low price would be telling you that, well, the alternative uses for this land, the vineyard is grown on and the labour and so on, they're not particularly high. Like if they weren't going to make wine, they wouldn't be doing too much of value. And so that's a good, so that's a relatively cheap way of producing wine, and therefore you stick with that. This is the sort of way that market prices contain information.

They tell you how much you're taking away from other people when you consume a particular good, whether that good is a slab of steel or a car or an ice cream or whatever. They tell you how much you're taking away from other people. And so you will naturally try and reduce the amount that you'll. you take away from other people in order to get the same good. Now, of course, you're not thinking about other people when you do that. Even if you were, you wouldn't, absent prices, you wouldn't have a clue how much you were taking away from other people, consuming this ice cream or that ice cream or this lump of steel

versus doing it some other way. You wouldn't have any idea. Prices give you that information. And so by adjusting choices at the margin and using prices as a source of information like that, people coordinate their production and consumption of goods so as to... to maximize efficiency, producer and consumer efficiency, and in doing so, they're maximized total surplus, as discussed before. Markets are cleared, supply and demand are equalized.

People can buy and sell the goods that they want, and the economy works well. And that hopefully gives you a bit of a sense of how something so complicated is the economy can function without a central planner, without a government bureau doing it all or working it all out. it arises spontaneously, in a sense, from the voluntary actions of millions of individuals pursuing their own self-interest. So in a later episode, I'll talk more about other mechanisms by which the free market works, including the profit motive and freedom of competition. Today, I've only focused on the price system, but there are other elements too. But until then, hopefully you've learned something, and I'll speak to you next time.