No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Five: Supply & Demand: Markets at Work 111 PRICES AS INFORMATION SIGNALS Before we show how market equilibrium prices are determined, we should begin a discussion that will underpin the logic of economics: why do we really care about the accuracy of market prices? After all, most of us think like consumers, and the obvious best price is free ! Or at least, we’d like the lowest price possible. Some of us think like producers; perhaps we want prices to be as high as possible to increase our profits. Yet this text will argue that first of all, high or low prices without context are meaningless terms—we always ask low or high compared to what , since we know that only relative prices matter. For instance, do we really care if we wake up and find all prices doubled, with our income doubled as well? Would we complain about prices being too high? Or if our income and all prices were cut in half by tomorrow morning, would we feel richer? But second and most important, prices (and, as we’ll discuss later, profits and losses) need to reflect underlying consumer preferences or we will see precious capital squandered and society will be worse off as a result. This is a very difficult concept for some people to accept emotionally when unplanned price changes directly affect their pocketbook, but it is very possible to understand when we rationally abstract ourselves out of the issue at hand. Let me use the example that usually causes people to abandon economic logic: we hate rising gas prices! Assume that the gasoline refineries along the Gulf Coast are in the path of a Category 5 hurricane. Gasoline prices will rise, even before the hurricane hits. People lament “why is big oil raising prices on gasoline? The hurricane hasn’t even hit yet, and they’re jacking up prices! They paid a lot less for the gas they’re selling me; this isn’t fair!” While I sympathize with this thought process, there are actually reasons why I want “big oil” to raise prices quickly. Let’s say that gasoline rises from $2.50 a gallon to $3.50 per gallon. Recall from the law of demand, that as prices rise, quantity demanded will fall, as seen in Figure 5.1 . While we might each individually like cheaper gasoline prices, we know that in the very near future (when the hurricane hits) there will be less total gasoline available for P ($) Q (#) Q 1 P 1 D P 2 Q 2 Figure 5.1, Reduction in Quantity Demanded with a hike in prices. If the price of gasoline rises from P 1 to P 2 , the quantity demanded will fall from Q 1 to Q 2 . People will respond to the price incentives they receive and will demand less gasoline. Given there is now an impending shortage of gasoline (assumed in our example in the text), people are responding in a socially optimal direction, by reducing consumption and reserving the remaining gasoline for more highly valued uses.