A Bit of Economics — Part 4

{Read part 3 here.}

People produce and consume stuff. Division of labor and specialization require that they consume what they haven’t produced and produce what they don’t intend to consume. The bridge between production and consumption is the opportunity to exchange or trade. Trades happen in markets.

People are constantly being guided in their production and consumption decisions by prices. Prices convey information to all market participants. The price of a good — be it cars or carrots — tells us something about the world. The amount we buy depends on the price, and our willingness and our ability to pay for it.

Our preferences determine our willingness to pay to consume stuff. A vegetarian would not pay anything for fish (or even pay to not to have to eat fish) while a Bengali like me will willingly pay a lot for the right kind of fish. Preferences aside, ability matters too. I prefer a Ferrari over a Honda but my budget constraint puts that out of my reach. Conversely, there are things that I can afford but don’t consume because of my preferences.

Take a few billion people with different preferences, different budgets, billions of different products and services, and you have a huge big mess. Who is going to produce all that stuff, and how are we going to distribute all those hundreds of billions of items to those billions of people? No one has the knowledge required to know the shifting preferences, changing budget constraints, productive capacities, talents and skills of the billions of producers and consumers, large and small.

Even in our individual lives, we have a had time figuring out how to allocate our time most productively and how to allocate our limited budgets among the various things we would like to have. (Even billionaires, who are fortunate enough not to have to worry about prices are limited by the fact that they too have only 24 hours in a day.) At the scale of just a few hundred people it would be an absolute nightmare to solve this problem. Imagine trying to get that done for a few billion.

But somehow it all gets gone. The world does not descend into total chaos. How? It’s a fantastic process that is called the Market. The market is that process that distributes the information needed to all market participants who then gain the knowledge they need to do to keep the world not only functioning but actually getting better all the time. It allows billions of people to allocate their resources as best as they can. This information that the market produces is called prices.

Markets processes generate prices. Prices — billions of prices — aggregate all relevant information in an easy to understand form. And the market process also conveys prices to all those who need it.

Prices guide producers. When the price of widgets goes up, producers are guided to produce more widgets. If the price is too low, inefficient producers — producers whose cost of production is higher than the price — exit the business. When prices go up, the less efficient producers enter the market. That is why the quantity supplied to the market goes up when prices go up. That is why the supply curve (the relationship between prices and quantities supplied) slopes up.

Products require factors. (To get the product, you have to “multiply” the factors of production.)  There are factor markets. Whatever factors are needed, there are factor markets which connect buyers of factors and to sellers of factors.

Prices guide consumers. When the price rises, consumers economize. They consume less and/or shift their consumption to substitutes. When the price of coffee goes up, some shift to consuming tea. That increases the demand (shifts the demand function) for tea, which induces an increase in the price of tea. The prices of substitutes move in the same direction — and therefore signal to producers of coffee and producers of tea to increase their supply of coffee and tea.

It’s a very elegant dance that is orchestrated by the market’s price signals. But why do the producers dance? What motivates them? We’ll go into that in the next bit.

Bonus material from a blog post from 2017:

“At the heart of economics is a scientific mystery: How is it that the pricing system accomplishes the world’s work without anyone being in charge? Like language, no one invented it. None of us could have invented it, and its operation depends in no way on anyone’s comprehension or understanding of it. … The pricing system–How is order produced from freedom of choice?–is a scientific mystery as deep, fundamental and inspiring as that of the expanding universe or the forces that bind matter.

That’s Vernon Smith, who was awarded the 2002 Nobel Memorial Prize in Economic Sciences

The human condition is one of limited knowledge, limited foresight, uncertainty and ignorance about the future — everything that doom grand plans to failure. Certainly, humans can engineer machines with some degree of success. However, these machines are inanimate objects made of materials that have no will or volition. Social engineering fails because the material at hand are people who have no particular desire, nor the ability, to selflessly obey someone for some “greater good.”

Apart from the above mystery identified by Vernon Smith, there’s another mystery: why do some people endlessly attempt social engineering when every past attempt has resulted in wastage at best, and at worst, untold misery and death visited on hundreds of millions?

India’s planners have consistently created monstrous disasters. Yet every new set of leaders believe that they will succeed where others have spectacularly failed. It would be interesting if some journalist had the basic curiosity to ask Indian politicians this simple question: why?

{Read part 5 here.}

 

 

 

Author: Atanu Dey

Economist.

3 thoughts on “A Bit of Economics — Part 4”

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