Today we have a healthy distraction for you. A couple of days ago I dropped a bombshell — Price Mechanism — and called it a magician. But what exactly is the price mechanism and how does it function?
We will eventually go into a lot more detail about this but for now here’s a teaser.
A Peek into the Past
Once upon a time, many believed that the fundamental problems of economics could be solved by governments if only they had access to superior statistics and aggregated data. Ideas such as communism and socialism were on the rise.
But an economist named Friedrich Hayek thought differently. During his time, Hayek was one of the thought leaders championing for the free market and capitalism, and his intellectual opponent was John Maynard Keynes.
Here’s a contemporary characterisation of their rivalry:
Hayek argued in his seminal works that the unfettered market and price mechanism are essential for people to make good decisions. These prices, he claimed, contains information about preferences, costs, and opportunities — information that are often dispersed, subjective, and private or unknown to most.
Hayek famously described the price mechanism as a sort of information aggregating machine: “the price system as a kind of machinery for registering change, or a system of telecommunications which enables individual producers to watch merely the movement of a few pointers… The marvel is that in a case like that of a scarcity of one raw material, without an order being issued, without more than perhaps a handful of people knowing the cause, tens of thousands of people whose identity could not be ascertained by months of investigation, are made to use the material or its products more sparingly; that is, they move in the right direction.”
TL;DR: Prices contain important information and solve the scarcity problems in society. Generally, governments should not interfere in prices.
Is it true though? Should governments not intervene in markets at all? You will find out as we move along. 🙂
These days Hayek’s ideas are out of fashion again because the financial crisis in ’08 reminded everyone that over-reliance on markets and prices can be disastrous. To deal with the mess left behind by the crisis, central banks of many developed economies — US, UK, Japan, and recently the Eurozone — have lowered interest rates to near-zero and launched huge stimulus packages (i.e. quantitative easing). Prices are certainly distorted, but is it justifiable?
Difficult questions… But we will get there.
Till next time, dream economics.
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The ideas of economists and political philosophers, both when they are right and when they are wrong are more powerful than is commonly understood. Indeed, the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually slaves of some defunct economist.
— John Maynard Keynes