An astonishing fact about Amazon, the giant retailer which aims to sell everything to everybody, is that it adjusts its prices over 2.5 million times daily. Let that sink in: two thousand five hundred thousand times a day. Around 100,000 price changes an hour. Granted Amazon has over 250 million SKUs (stock keeping units) on its catalog in the US. (See the data on US and other countries here, as of Aug 2014.) Still, that fact bears witness to what technology can do and what market competition can achieve in terms of economic efficiency.
This “economic efficiency” thing may leave the lay person cold but to an economist it is thrilling to the core. Speaking for myself, I recall the exultation I felt when I first understood what prices are and how the market discovers prices. It was a revelation, an “Aha!” moment for me. Whenever I understand a fundamental aspect of the world (such as the theory of relativity, theory of computation, theory of evolution, the scientific method, game theory, and so on), I feel joy. Price theory is one such area and I continue to learn about it all the time.
Like many other great ideas, price theory is at once very complicated and very simple. It is simple enough that the average 10th-grader can grasp the essentials after a few hours of instructions and a little bit of pondering. But it is complicated enough that volumes have been written in exposition. (See this for a list of great text books on the matter.) I believe that it is good to know what price means; it helps us avoid falling into stupid traps that ignorance leads the untutored into.
We all intuitively know what we mean by price: it’s what it says on the price list or the menu. Bananas cost 19 cents each at Trader Joe’s. You give up 19 cents and you get a banana in exchange. You take the price as a given. You are a “price-taker.” Someone at TJ’s has set that price, someone had to make that decision.
It is not an arbitrary decision. TJ’s could set the price at $1 each but it would not sell too many at that price because I will buy bananas from the Safeway next door. In markets where there are more than one seller, you don’t have too much freedom to set prices either. (Price and cost are closely related concepts. To you, bananas cost 19c at TJ’s because that’s the price. To TJ’s, (let’s assume) bananas cost 12c each, when it buys it from some wholesaler of bananas.)
The major function of prices is that they convey information. We constantly need to make decisions. To make those decisions, we need to know. That knowledge is most economically (that is, at the least cost to us) conveyed to us through the prices we face. We decide on how many bananas to buy and from where partly on what the price of bananas is. We know our preferences and our needs, we know how much money we can spend on food, etc, and based on our knowledge of ourselves, and taking prices into consideration, we decide for ourselves how much of what to consume.
Hidden behind the prices we face are all kinds of information that we not only don’t need to know but also not possible for us to know. We don’t need to know how much the producer got paid for the bananas, how much it cost to transport it to the retailer, how much the retailer paid in rents and salaries, and a million other things that happened between the growing of the banana and our eating it. All we need to know is its price when we have to make our decision whether or not to buy that banana. Prices convey information compactly and this compact information is useful knowledge to all participants in market transactions.
There are untold millions of prices out there because there are untold millions of items out there, and there are millions of sellers (firms and individuals) and billions of buyers. Who decides on all these prices? The answer is “no one and every one.” Every time you buy or sell something, you make an infinitesimally small difference in the price. The price of every item depends on the prices of everything. All those millions of prices are determined, in the ultimate analysis, jointly — together and not in isolation — through a process that is incredibly complex, intertwined, connected in time and space, interrelated, multi-directional, grand and incomprehensible to any single or group mind.
I think the closest metaphor to the web of information that is at the foundation of the market price mechanism is Indra’s web of jewels. It is an extravagant web with jewels at each of its infinite nodes. Each jewel reflects every other jewel, and each reflection itself reflects the infinite reflections . . .
“If we now arbitrarily select one of these jewels for inspection and look closely at it, we will discover that in its polished surface there are reflected all the other jewels in the net, infinite in number. Not only that, but each of the jewels reflected in this one jewel is also reflecting all the other jewels, so that there is an infinite reflecting process occurring.” [Wiki]
Each price is like a jewel in Indra’s infinite web, reflecting all the other prices within itself. When you change any price, the effect is transmitted throughout the entire web and affects every other node. Each node is finite but is infinitely influenced and in turn influences infinitely. Given our finite cognitive capabilities, all we need to look at is the one node that is closest to us but that is sufficient for us to “know” what the infinite web contains in its entirety. Prices, as said before, economize on knowledge.
Repeat after me: Prices convey information.
This information is useful to us for knowing the scarcity or abundance of stuff. Gas prices at the pump are going down around here. Yesterday I filled up at the local Costco at $2.34 a gallon; a year ago it was close to $4 a gallon. How much I drive is influenced by some events that I have no control over and little knowledge of. There are global forces at work — OPEC decisions, oil shale reserves, fracking technology, etc — that I only dimly understand. Regardless, what I do is not unaffected by some trade in an unknown (and unknowable) part of the world.
Prices move in response to shifts in supply and demand. If the supply increases and/or the demand falls, prices head down; if supply decreases and/or demand increases, prices move up. The movement of prices tells us which way the wind if blowing and therefore how to trim our sails.
Prices are the ultimate rationing mechanism. When the quantity demanded is high, the price goes up and therefore only those who are willing to pay the high price are able to get the limited supply. Interfering with the price is generally a bad idea because it sends the wrong signal (information) to people, and they are unable to make the economically efficient decision.
One commonplace example of the rationing mechanism of prices is the cost of air tickets. During holiday season, ticket prices go up. Are the airlines “price gouging”? Not necessarily. There are only these many seats on any given day. During the holiday season, many more people want to fly than there are seats available. The higher than normal prices reflect the higher than normal demand. The high prices send a simple message: if you wish to fly desperately enough, you will have a seat provided you are willing to pay for it. And if you are not willing to pay the high price, you are clearly not desperate enough to need that seat and therefore that seat should go to someone more willing to pay than you.
Now imagine that some agency is able to dictate prices of air tickets and imagine further that that agency decides that airlines will be prohibited from raising prices during the holiday season. I realize that this is an unrealistic scenario. No agency — least of all a government — can be so insane as to imagine that it can improve general well-being by controlling prices but humor me for a moment. Imagine that the government of some banana republic is retarded enough to dictate prices to airlines and decrees that airlines cannot “over charge” their customers and puts a price ceiling of $X on tickets during holiday season.
Assume that the price ceiling is binding in the sense that without the ceiling, the price would have been higher. This means that under the price-ceiling regime, the quantity demanded will be higher than the quantity on supply. Some people will get seats at $X per seat but others will have to do without a seat. Some of those without a seat may have an urgent need to buy a seat and therefore may be willing to pay a lot more than $X but that transaction will not happen because the government of the banana republic has prohibited that trade. This leads to misery all around. Which is what characterizes banana republics: government induced, government engineered misery.
Engineered Misery, Planned Poverty
Economics is not quantum mechanics and I will not make the self-serving claim that economists know it all. But insanely idiotic policies generally implemented by the government of banana republics usually go against elementary economic logic. Dear old Milton Friedman put it thusly in his book “Free to Choose” (1979):
“Economists may not know much. But we know one thing very well: how to produce surpluses and shortages. Do you want a surplus? Have the government legislate a minimum price that is above the price that would otherwise prevail.
. . .
Do you want a shortage? Have the government legislate a maximum price that is below the price that would otherwise prevail.”
Shortages and congestion are, and have been for millennia, a fact of life. In some parts of the world, it has become so much a part of daily life that it is considered an unalterable fact of nature, just like the seasons. One has to live with it and somehow cope. But unlike the seasons, chronic shortages have to be engineered and indeed if you look at it carefully, you will see the grasping hand of some bureaucrat or politician choking the normal functioning of the market. In some fortunate places, thankfully for whatever reasons, the simple but essential truths of economics have been recognized and the government does not interfere as much, and the market is allowed to function.
Markets solve the problem of shortages — they allocate resources efficiently — through the actions of individuals motivated by their desire to make the best of what they can do given their limited resources, and guided by their own assessment of their needs, preferences and capabilities. This knowledge is dispersed throughout the entire nexus of voluntary trade. Everyone has local knowledge and no one has (or can know) it all. Everyone needs to know the prices of only those things that matter to him or her, and disregard the rest.
In his book, “The Use of Knowledge in Society,” Friedrich Hayek wrote:
The peculiar character of the problem of a rational economic order is determined precisely by the fact that the knowledge of the circumstances of which we must make use never exists in concentrated or integrated form but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess. The economic problem of society is thus not merely a problem of how to allocate “given” resources—if “given” is taken to mean given to a single mind which deliberately solves the problem set by these “data.” It is rather a problem of how to secure the best use of resources known to any of the members of society, for ends whose relative importance only these individuals know. Or, to put it briefly, it is a problem of the utilization of knowledge which is not given to anyone in its totality.
The Fatal Mix of Hubris, Ignorance and Stupidity
At the core of most human misery inflicted on humans by humans lies the insidious evil of hubris fed by ignorance and nurtured by stupidity. The hubris arises out of the drive to control others, to make others do one’s bidding. Ignorance of simple truths about the nature of reality makes their intervention harmful even if you grant that perhaps they don’t intend harm. Stupidity is alas a common affliction that no one — without exception — is immune from. All of us labor under the combined burden of hubris, ignorance and stupidity to some degree or the other but most of us don’t have the power to interfere in the fates of millions. But the politicians and bureaucrats do.
The newspapers routinely report instances of gross, unpardonable stupidity. For instance? Take this report that a friend pointed me to yesterday. (Hat tip: Alok L.) The Economic Times headline reads “Government considering capping economy air fares at Rs 20,000. (Dec 25):”
The civil aviation ministry is considering a cap on last minute economy class fares after members of Parliament criticised the recent price hikes by airlines.
The limit may be set at Rs 20,000. “Severe criticism is there from many quarters, including members of Parliament, tour operators, passengers, etc, that the airline companies are charging very high fares on the immediate day preceding travel and the date of actual travel,” the ministry said in an internal note.
Why should the cap be at that high price of Rs 20,000? Why not just Rs 200? Wouldn’t that make air travel really affordable? And while they are at it, why not assign quotas for minorities and reservations for the “underprivileged”?
Read the entire news item. That is what I call USDA Grade AA top shelf insanity. It may appear to some that this is just some garden variety government stupidity. After all, you may say, the civil aviation ministry is probably run by a bunch of retarded bureaucrats who wouldn’t know anything about dynamic pricing even if their lives depended on it. It’s a minor matter, you would say. But it is not. All those little bits of brainless interference adds up to immense welfare losses and eventually impoverishes the country. India’s descent into being a banana republic has been engineered by such idiocy.
If I could, I would slap the idiots at the civil aviation ministry silly and drive some sense into their thick skulls. But perhaps the disease doesn’t stop there. It goes all the way up to the top — the constitution. That needs to be replaced, not just the idiot functionaries.
 What’s economic efficiency and how is it defined? Efficient means that there is no waste. A distribution is considered efficient if no changes can be made to the distribution to make someone better off without someone being made worse off. This is known as “allocative” or “Pareto optimality.” This is purely an efficiency criterion and has nothing to do with equity. For instance, if we divide a cookie between the two of us, and some of it falls into the trash, the division is not efficient. Thus efficiency requires that there be no waste of resources. Optimality is defined with reference to some criterion and subject to some constraint. In the case of the cookie, the division could be said to be optimal if we achieve a division that maximizes our combined utility subject to some constraint such as that neither of us receives less than, say, 25% of the cookie. An efficient division need not be optimal. (return)