When economists teach welfare analysis, they demonstrate that the “gains from trade” in an economy come as a result of two people transacting that place different values on a good. Typically the transactions are characterized as between a buyer (who might value a pair of sunglasses at $90) and a seller (who might be able to produce it for $30), but that need not be the case. It is simply any exchange between any two actors who value things differently.
In the example above, the wealth that is created amounts to $60 and is not dependent on the price paid. The price simply distributes those gains between the parties. So, if the price was agreed upon to be $80, then the consumer benefited by $10 while the producer benefited by $50. If the price was $35, the consumer benefited by $55 and the seller by $5. In either case, the gain was $60 – because they gain has nothing at all to do with the price.
In fact, if President Obama decided that consumers were entitled to sunglasses (e.g. healthcare) and enslaved the seller, and forced him to produce the glasses and “sell” them to any consumer for a price of $0, the gains would STILL be $60 – in this case $90 of gain to consumers and $30 of losses to sellers. Or if the President decided that the sunglass industry was important to secure votes from, he could institute a mandate where all drivers had to purchase sunglasses, and that those sunglasses could only be sold for a price of $283.34. In this case the wealth created from each sunglasses sold is still $60! It is just that the gains are now split in favor of the sellers – who gain $253.34 and the buyers are worse off by $193.34.
This might scare some of you. If the only thing the sunglasses czar needed to do was to figure out the appropriate number of sunglasses to produce independent of prices, costs, values, etc. then you might think they would be empowered to try this in all manner of industries. But even if the Messiah was visited from an angel on high, who told him the appropriate number of sunglasses to mandate the production and sale of, we will still have a serious problem on our hands.
That problem, of course, is that prices play two very important roles (aside from divvying up the gains from trade). They not only provide the necessary knowledge by which we know the correct number of sunglasses to produce, once we have that number in hand, they insure that those doing the producing are those that can do so for the lowest cost, and that those doing the buying are actually those that value it the most. We can spend another post later on discussing this important proof, but I wanted to focus on the role of prices in allocating goods to those that value them the most.
I demonstrate extensively in every class that prices are important because they signal to potential consumers the real tradeoffs they must face when they consider purchasing a good. If the price of sunglasses is $50, that represents $50 of other goods and services I cannot consume if I choose to purchase a pair. Thus, if I prefer $50 of other goods and services to that pair of sunglasses, I hold off on purchasing the glasses when they are priced at $50. If I happen to enjoy the services that the sunglasses provide me with more than what I would do if I spent those resources elsewhere, then I would buy them. Notice how my decision would change if there were no money price to allocate the good. If glasses were priced at zero, I am very likely to purchase them, even though I do not value them nearly as much as someone else, and even though I do not value them as much as the resources that were used to make those glasses. But since I did not have to part with an equivalent amount of resources, I purchased them. The world is poorer for it, even if I am nominally better off.
If the price was higher, not only is that an important signal to me about the tradeoffs I must make, but those prices also FORCE me to consider the values and wants and desires of other consumers. And prices do this in an insanely efficient way. No person has to ask me NOT to purchase sunglasses so that there is enough for everyone else. And no one person has to survey anyone else about how much they like sunglasses (we’d all have an incentive to lie anyone). But by looking at the price of $50 (or whatever it is), I am forced to consider how much everyone else likes sunglasses. If the price of $50 seems to hefty for me, then I do not buy them –> thereby leaving them (sharing if you may) for someone else that wants them more than me. But if that price was less, or even zero, there would be nothing preventing me from taking them, even if others valued them more. And all of this is done without moral suasion, pleading, begging, political rationing, nothing.
Contrast this to what happens when Lord Obama makes the price zero, he encourages me NOT to care about what others think or want – in fact, the socialist dream of providing goods free to everyone in the name of community, encourages precisely the opposite behavior in us. Just think what would happen if Amazon announced today that the Kindle was “free” to the first 100,000 customers that showed up in some particular place at some particular time. And compare it to what happens when the price is $495.
But the reason for the title of this post is this – even my best students are confused when I argue that willingness to pay a money price is the best way indicator of the value of a good to someone, and certainly allocating goods via the price system and relying on willingness to pay is the only just way to ration scarce goods. Why? Because they fall into the collectivist trap that leads them to forget that candy bars do not simply rain down from the sky. There is not enough stuff to go around. And once you recognize this fact … this unrelenting and tyrannical fact … then you must understand that something has to allocate who gets it (and in fact who produces it). If not the price system, then some other mechanism gets in line (no pun intended). It can be queuing, it can be lottery, it can be force, it can be good looks, it can be bribes, it can be political decisions, etc. And ALL of these are FAR inferior ways of allocating goods.
Why? Because even if those allocating mechanisms got goods to the people that did in fact value them the most – they ALL ignore the fact that producers need to be incentivized to deliver the goods. There is simply not enough compassion, goodwill, love or any of that to go around to induce me to make sunglasses for you. But furthermore, each of those rationing mechanisms is entirely wasteful. All of the things that people do under those mechanisms to compete for the goods (and compete they will my socialist brother), destroy wealth. That is because the resources used to get to the front of the line, to rig the lottery, the get better looking, could have been employed productively in the creation of goods and services that were of value to the rest of us. Otherwise these rationing mechanisms are all like arms-races, zero-sum games that happen to be the Pet Peeve of many lefty, socialist, corporatists these days. Why is it that they can nitpick about the possibility of zero-sum competition in certain market elements, and then forget that once they impose their political and paternalistic fix for such competition, they MUST, by definition, move to a system that is even more “arms-racy”? Read any of the behavioralists and the conspicuous consumptionists to see what I mean.
But that leaves un-addressed the notion that willingness to pay via money prices is the way to go. I briefly sketched out above why using this mechanism actually encourages positive sum economic outcomes. Why? Because when goods are allocated using the price system, you get things by bidding more for them. But if you lose in the process of bidding, you are still left with all of the goods and services that you had to create in order to secure the money in the first place. Society is richer, and you can still bid for other goods in a world where more goods have been created. Beyond that, why is willingness to pay (as revealed by people’s actual behavior as opposed to what they tell an interviewer) still a great measure of how much one values a good? Well, if you understand that money is simply a short-term financial asset that represents a claim on goods and services produced, then you realize that “willingness-to-pay” is simply shorthand for saying “how much labor effort I am willing to exert to produce goods and services that are valuable to others.” And once you make that realization, is there any better indication of how much someone wants something than what they are willing to sacrifice to get it? Simply standing in line longer than someone else is not the same thing. You can even argue that such a thing is inversely related to how much someone really values a good or service.
I still get confusion because people argue that many people have no money, so allocating goods by money prices is unfair and unjust. But once you understand that money simply represents goods and services that you have produced, and that are found to be valuable by your fellow citizens, you are partway to addressing this dilemma. Everyone has the ability to produce – and the natural state of nature is non-production – it is poverty. Wealth and happiness is not an entitlement, they can only be possible when you take efforts to produce things of value (broadly defined too). The collectivists among us run away from this reality by talking about “causes of poverty” as if nothingness has a cause. Wealth and somethingness is the thing to be explained, and it is up to the astute reader to understand what things make it difficult for people to move from a state of nothingness and into a state of somethingness.
But that’s just not fair they all say. We will address this in extreme detail in the near future. Let me end with a simple story, and one that is not apocryphal. People without the means to purchase sunglasses (for example) often have people advocating on their behalf claiming that if they only had the money (and remember what money means) that they would, in fact, but them for $50. Does a commercial societarian such as myself have any issues with that? No – if they truly valued it like they said they do, then we should see the following. In every case when someone “gifts” a pair of sunglasses to them, we should see them hold onto the sunglasses. But what do we see in most cases? We see them turn around and sell them for $50, or even less, and then use those proceeds to purchase other goods and services that they value. When it comes time to put their money where their mouth is, you know what typically happens.
Next up – what people MUST mean when they argue that Walmart is exploiting its workers.