In an almost daily debate over economic and monetary policy politicians complain if prices — such as home prices — do not rise, and some complain if they think other prices — such as health care prices — are going up too much.
This situation begs the question: do we want rising prices or falling prices?
The truth is that prices are neutral, at least as far as social welfare is concerned. Constant changes in prices indicate that an economy is working to coordinate the wants and needs of consumers and entrepreneurs. They are the mechanism by which buyers communicate with sellers, and vice versa.
For this reason, before we can understand the role of prices, it is important to distinguish between “prices” and “offers,” even if in our daily dealings we tend to conflate both terms. A price is the ratio at which two commodities have been interchanged by two individuals in a concrete transaction. However, the “prices” we see in a supermarket for each of the available goods are not actually prices, but offers, and will only become prices if the good is actually bought. If the “price” for an apple is set at, say, 100 euros per apple, and consequently no one buys any apples, it would be wrong to say that the price of an apple is 100 euros, just because the supermarket tried to sell apples at such a price.
With this in mind, let’s try to answer the question: does social welfare improve, when prices increase or when prices decrease? If the price of a concrete good rises, it is clear that people who already own the good will be better off. Those people which have the means to produce it, be it labor or assets, will likely profit from the increase too. Conversely, people who do not own the good will be worse off, especially if they are planning to buy it in the short term. The contrary will of course happen if the price goes down.
So, what is the balance for society? There is no answer. In fact, from the point of view of “society,” the rise and fall of various prices are simply the marketplace at work. For concrete individuals in specific concrete transactions, there are costs and benefits, but in relation to “social welfare” or “the economy,” we can conclude nothing.
The Role of Prices in Society
However, this is not the end of the story: prices have also a fundamental role to play in the market. They are the signals by which entrepreneurs guide their decisions on investment. As such, prices are an indicator of the relative scarcity of a good with respect to its uses.
If a price rises, this means that a good is more valued by society, and conveys the signal to entrepreneurs that more resources should be deployed to the production of that good, because this is what society is currently demanding. Conversely, if a price decreases, the good is losing value for society, and resources should be moved from its production to other more productive uses. This process, as explained, is not automatic, but driven by entrepreneurs using prices as signals.
When We Mess With Prices
What happens if prices are tampered with through price controls or other coercive government controls? Of course, the first effect will be that some individuals will lose and others will win. For example, if prices are not allowed to increase, people owning the product — or the means of production — will lose wealth, while people intending to buy it will increase their own wealth. Politicians normally think that this is good for “the people,” because — in the minds of many populists — firms are “rich” and this action re-distributes wealth from “the rich” to other people.
This may be good for the individual consumer for a particular transaction; but individuals are much more than consumers: they may be shareholders of firms, or they may have a pension plan which is invested in the firm, or they may work for the affected enterprise or for any of their providers upstream in the value chain. So, in the end, it is not even easy to clarify if a concrete individual, much less society, is better or worse off as a result of the price control.
However, this is not the gravest effect of price tampering. The biggest problem is that disrupting the price system jams the price signal system, and thus entrepreneurs are hindered from calculating how they should devote resources to a particular enterprise. The entrepreneurial process will go on, but the resources will be taken to the wrong places, impoverishing the society with each investment.
One other thing should be considered: entrepreneurs, being human, may make mistakes. An entrepreneur may offer a good at too a high “price” and then find he is not able to sell enough units to make the investment worthwhile, being forced to bring the price down in order to increase the sales. This does not make the initial price wrong and the new price right: it just means that the entrepreneur is reacting to the new information acquired after the first attempt. If further information comes along, the price may be revised again, be it upward or downward. This is the essence of the entrepreneurial process, to react to changes in the environment trying always to adapt to the new preferences shown or anticipated by individuals.
To maximize this essential interplay between consumers and producers — through which consumers exercise their control over the marketplace and even society at large — the goal needs to be freedom in prices, and not “high” prices or “low” prices. Tampering with prices prevents them from doing what they’re supposed to do, making the process of resource allocation harder and more ineffective. And this would definitely harm all of us.