We teach Austrian Economics in a fun way!

Price system: free market vs. government intervention

What is the role of the prices on the market? What happens when the government interferes with the market and sets a maximum or minimum price at a level other than the free market would? Why is it so important to leave prices to the market?

One of the key facts concerning the market economy is that people exchange goods between themselves in order to improve their well-being. Every exchange benefits both of its parties, at least at the outset. Hence it is crucial for such exchanges to be as effective as possible. Product prices are shaped by market exchanges. Thomas Taylor wrote in this vein: “The prices that emerge in the market are not unexplainable; they always are the result of subjective valuations expressed by individuals who choose to buy or sell or to abstain from either action.” The supply and demand curves for a given good are made up of a multitude of individual consumer and producer preferences. Every one of us by acting as a consumer creates and adds to his own demand curve for every good. Every one of us determines how many units of a good he or she can buy at a certain price according to, as we have said in the Value of Things video, the law of decreasing marginal utility. I will buy five apples for a price of $1 each, and two for $3 each, but I won’t buy any for $5 an apple. Your own preferences may differ.

The people on the market establish a market-clearing price for each and every good. Too high a price will cause surpluses, with producers unwilling to sell their stock of goods; on the other hand, too low a price will cause shortages, with the entire stock sold out before all consumer demand could be satisfied. At very low prices manufacturers may even refuse to sell goods and decide to store them in anticipation of higher prices in future.

How does the market deal with it? Manufacturers will eventually have to lower the price not to have their inventories withheld from the market indefinitely. Consumers, in turn, by quickly buying out the undervalued good, will convince the producers to raise the price; higher price will then satisfy consumer demand by encouraging producers to produce more, and possibly influence other producers to enter the market.

It is crucial to emphasize that the market-clearing price is not one set in stone forever. Any change in supply capabilities or in human preferences will shift supply or demand curves, respectively, and then the market will again be looking for a new market-clearing price.

This process may seem complicated or difficult, but all of this happens naturally in the marketplace. The market regulates itself through the actions of its participants and does not need any external interventions to work well. On the contrary, any intervention causes the market to be less efficient in satisfying human needs. Let’s see why.

Suppose a terrible drought fell upon some region. Faucets dried out in houses. Small inventories of bottled water were beginning to vanish quickly. Casual shoppers trying to buy water were driven to the brink of violence. Water became so valuable that shopkeepers raised prices from $2 to $10 a bottle, and people still wanted to buy it. The situation lasted for 3 days, after which a representative of the government came and said: “Citizens! We cannot allow for ordinary men to be coerced to pay $10 for a bottle of water they need to live. Today the Congress adopted a law that sets a maximum price water to $2 a bottle.”

Given the lowered price all stocks of water have been exhausted in 2 hours. Now the same people who have limited themselves to buying 1 bottle a day at $10 a bottle, now bought 5 bottles, thus making it impossible for some people to get any water. By artificially lowering the price the government caused an immediate shortage. What then needed to be done to hold back the crisis? The answer is: nothing. Higher prices would encourage bottled water producers from neighboring regions where water is abundant, and they would soon begin to supply it. The existing producers would also go to greater lengths to find more water to sell in spite of the drought. The entrepreneurs wouldn’t do this because of their benevolence, but merely in order to get ahead of their competitors in supplying their clients with water in a competitive market. In effect there would be more water, and so its price would start to return to normal. The higher price thus allows for more effective distribution of a rare good in time of crisis, reduces its consumption, and by encouraging water companies to invest in production eases things up along the road. The artificial reduction of the price made for an immediate shortage of water for many, and played havoc with the chances of escaping the crisis quickly, as producers were discouraged from providing enough water.

Now imagine a different scenario.

There was a country producing 10,000 bushels of wheat per year. Some of the farmers invested in their businesses. They bought harvesters, tractors, irrigation systems and significantly improved production efficiency. The rest did not invest and consumed their earnings without second thought. Due to innovations adopted by the former group, the capacity to produce wheat increased to 15,000 bushels at the same price. Then the increased supply caused the price of wheat to fall. Less innovative group of farmers were troubled by this outcome. Because they did not invest, their costs were unchanged. Given the lowered price they began to lose money. So they contacted their representatives in Congress, and started public protests. Angrily they shouted: “The government has to do something!” Their political influence was powerful enough, and the government intervened. A minimum price of wheat equal to the original price was initially set. This, however, quickly caused production excesses. Consumers were still willing to buy only 10,000 bushels at the old price. Protests escalated, this time over wheat rotting idly inside grain elevators. The government reacted by imposing a cap on production per square mile to match the level of productivity of the least productive farmers. This, however, was unacceptable to more efficient farmers who invested their money precisely because they were counting on increasing their earnings by increasing production. They were left with innovative and expensive technology that they were now unable to use properly to achieve profitable levels of production. Finally, the government has decided to remove restrictions and buy all the surpluses. As a result, all consumers had to buy grain at the old price, while, additionally, paying for excess production in taxes. In the following years the surpluses of the wheat the government was trying to sell began to pile up, because the demand for it was too low at the offered price. The only thing the government could do other than collapsing the market price was simply to destroy all surpluses or export them at a discounted price, thereby supporting foreign markets at the expense of the domestic economy.

What should the government do? Once again: nothing. It should allow prices to fall because it’s in the interest of all consumers. Less efficient farmers would have to invest quickly or place their businesses in more capable hands. Every consumer of wheat who would buy it at a lower price would have extra money that could be spent on something more. For example on products soon to be produced by newly retrained farmers. The wealth of the society would increase.

Any intervention in prices is harmful. The same goes for wages. When a government sets a minimum wage, it creates a surplus of people willing to work and unable to find jobs. When a central bank lowers interest rates, it causes a scarcity of real resources. If we want our needs to be met most effectively, then prices should be left to the market.

2017-05-13T15:04:19+00:00