Reading: Lesson 1 – Role of Prices

 

 

Objectives:

Students will be able to…

• Explain the function of prices
• Identify the necessary requirements for a functioning price system
• Describe the role of profit and loss in the allocation of resources in society
• Understand how profits signal the successful serving of the needs of others

 

Related Standards:

Standard 7: Market Prices – A market exists when buyers and sellers interact. This interaction determines market prices and thereby allocates scarce goods and services.

Standard 8: Role of Prices – Prices send signals and provide incentives to buyers and sellers. When supply or demand changes, market prices adjust, affecting incentives.

Standard 9: Competition and Market Structure – Competition among sellers usually lowers costs and prices, and encourages producers to produce what consumers are willing and able to buy. Competition among buyers increases prices and allocates goods and services to those people who are willing and able to pay the most for them.

Lesson 1 – Role of Prices

 

Description: 

Irish playwright Oscar Wilde once called a cynic “A man who knows the price of everything and the value of nothing.” While no one could possible know either, or certainly both, prices do convey useful information. Prices help coordinate the actions of people in the market by communicating the local knowledge of individual producers and consumers and providing the incentives for people to act on that knowledge. In a complex economy, a freely functioning price system enables voluntary exchange and social cooperation. 

In this lesson, students will watch and discuss a short video about the “magic of prices” with Duke Professor, Michael Munger. Next, students will watch a video by Troy University professor, Dan Smith, who further explains how prices communicate valuable information throughout the economy. Finally, students will participate in an activity simulating a planned economy and a free market during which they will see the benefits of emergent prices.

 

Time Required:

45 min

 

Required Materials: 

Internet connection, writing instrument

Activity materials include:

• Record chart for blackboard or overhead transparency
• 50-75 pencils
• 100 assorted candies or candy bars
• "Production chips" (colored paper clips, poker chips, etc.)
• Ruble and dollar debit cards, two of each per student (8 per page)
• Two black markers
• Prizes for successful factory managers (large candy bar, fast food certificate, badges etc.)

 

Prerequisites:         

Module 3 – How Can Entrepreneurs Use Economics to Make Better Decisions?

Module 4 – How Does Trade Create Wealth?

 

 

 

 

5.1.A – Watch and discuss the following video using the questions below to guide your discussion [10 min]:

Video:(Learn Liberty, 4:33 min)

“According to Professor Michael Munger, prices (as in, the price of a carton of milk or a new car) are akin to magic. Prices “magically” convert countless pieces of dispersed, complex information into a single signal that conveys to sellers what they should do to best benefit society. By ignoring the price system, you’re really ignoring the needs of those whom you want to serve. This is the “magic” of the price system – it merges the needs of society with each seller’s desire for profit.”

Discussion Questions: What Do Prices “Know” That You Don’t?

1.  How does an entrepreneur know what and when to produce? What kind of knowledge do prices communicate?

1. Prices tell entrepreneurs what consumers value. Market prices are determined through the decisions made by buyers and sellers. Prices send signals and provide incentives to buyers and sellers. When supply or demand changes, market prices adjust accordingly. This affects incentives for both buyers and sellers.
2. Entrepreneurs drive production in the economy, but they are steered by the wants and needs of consumers. Ultimately, it is the consumer who determines what should be produced. Without prices, entrepreneurs don’t have a way of knowing what should be produced.
3. High prices for a good or service provide incentives for buyers to purchase less of that good or service and for producers to make or sell more of it.
4. Lower prices for a good or service provide incentives for buyers to purchase more of that good or service and for producers to make or sell less of it.

 

2.  What does it mean that farmer Al needs information about what he should produce that is “too dispersed” and “too specific” to learn?

1. Professor Michael Munger explains “Information is too dispersed, too complicated to solve the IDK problem through research – there’s just too much to know. Fortunately farmers don’t need a crystal ball because prices do exactly what we were hoping that the genie would do.”
2. The video shows that no one person can fully explain why a price is high or low – there is too much information out there to research all of it and the marketplace is constantly changing. It is also too hard to determine which information is relevant. Prices solve this problem by indicating which crop is in greater need. By choosing to plant soybeans, the crop with the higher profit, the farmer can solve the shortage, meet the demand and satisfy the requirements of innovation.
3. As shown by farmer Al, it was a waste of time researching the market because he should have just focused on what he was good at – running a farm. Had he used prices as a guide for what to plant and focused his time and resources into growing soybeans, he would have helped society more, made a decent profit and not have gone bankrupt.

 

 

 

3.  Why was farmer Moe able to rely solely on prices to determine what he should produce?

1. Farmer Moe was able to rely solely on prices to determine what he should produce because prices take into account all the relevant information in a marketplace about how people value a product.
2. Farmer Moe chose to plant the crop that would give him the highest profits – the crop that was most valuable to people. The higher prices of soy indicate that society needs more soybeans. This saves famer Moe from spending impossible amounts of time consuming research on each crop.

 

4.  Is it possible for entrepreneurs—or anyone else—to calculate profit and efficiently allocate resources without prices? Why or why not? What actions take place as the result of the calculations made by an entrepreneur?

1. It is not possible for entrepreneurs to determine profit or efficiently allocate resources without prices. Prices are an economic indicator that tell entrepreneurs how to put resources to their most efficient uses. Without prices entrepreneurs cannot determine how to put resources towards their most efficient use to meet the needs of people in society.
2. As explained in the video if an entrepreneur puts their resources towards their highest valued uses they help society to solve a shortage, meet a demand, and satisfy the requirements of innovation.

 

5.  If entrepreneurs determine the course of production, how are consumers sovereign?

1. As shown through the example in the video of Farmer Moe, entrepreneurs react to the incentive of prices and profit. When something has a greater demand, like soybeans, prices rise and more entrepreneurs will produce it.  Therefore, consumers have a good amount of influence on what will be produced.
2. If entrepreneurs produce something that is not valued by consumers they will have to produce something different in order to profit.

 

 

 

 

5.1.B – Watch and discuss the following video using the questions below to guide your discussion [5 min]:

Video:by Dan Smith (Learn Liberty, 2:25 min)

“Why are prices important? Prof. Daniel J. Smith of Troy University describes the role that prices play in generating, gathering, and transmitting information throughout the economy. Information about the supply and demand of different goods are dispersed among different buyers and sellers in an economy. Nobody has to know all this dispersed information; individuals only need to know the relative prices. Based on the simple information contained in a price, people adjust their behavior to account for conditions in supply and demand, even if they are unaware of that information.”

Discussion Questions: The Price System, Part 1: Information

1.  How do markets and prices help to coordinate the activities of the people in a complex economy?

1. According to Dr. Smith, the price system offers an information generating, gathering, and transmitting process that calls up widely dispersed information that no person or agency can know on their own.
2. These prices transmit local knowledge from buyers and seller and help to incentives people act on that knowledge. The result is coordination in a complex economy, even though no one person or group of people plans the coordination.

 

2.  How do prices influence people’s behavior regarding the buying and selling of tin, even if they do not know the specific market conditions for tin?

1. Prices help coordinate the actions of both producers and consumers. People automatically adjust their behavior when there is a change in price.
2. If resources became relatively scarcer, such as the example in the video of the collapsing tin mine, producers don’t need to know why prices have gone up, only that they can now charge more.  This leads producers to increase their output to take advantage of the higher prices. Consumers will use fewer products made with tin because of the higher prices.
3. Prices communicate the local knowledge of individual producers and consumers. This knowledge, transmitted through prices, directs resources to where they are needed most to satisfy the most urgent wants of consumers.

 

 

 

5.1.C – Self-Study: Read the chapter 15 “How the Price System Works” from Economics in One Lesson [15 min]: 

Article: Economics in One Lesson - How the Price System Works by Henry Hazlitt (FEE.org)

“The whole argument of this book may be summed up in the statement that in studying the effects of any given economic proposal we must trace not merely the immediate results but the results in the long run, not merely the primary consequences but the secondary consequences, and not merely the effects on some special group but the effects on everyone.”

 

 

 

Lesson Recap

• Prices convert dispersed, complex information into a single signal that conveys to sellers what they should do to best benefit society.

 

• Prices communicate the local knowledge of individuals in the market and provide incentives for people to act on that information. Prices are incentives wrapped in knowledge.

 

• Prices help coordinate the actions of both producers and consumers.

 

 

Additional Resources

Article: Market Prices vs Communist Demand by Henry Hazlitt (FEE.org)

“So when we examine closely how the two systems, communism and free market economy, work in detail—the one controlled by bureaucrats imposing by fiat a single overall production plan from the top, the other operating through the free and flexible production and consumption choices of millions of individuals, with their individual decisions constantly modified and coordinated by a system of free market prices—we can see why the capitalistic system is so enormously productive, and why the overall production plans of the communist bureaucrats must go wrong chronically and necessarily, and not merely because of bad luck or bad weather.”

 

Article: Profits Versus Love by Russell Roberts (FEE.org)

“Here’s the key insight of economics: some of those folks who go down with a song in their hearts because they know they’re helping others would have stayed home if the price of lumber hadn’t soared. It’s hard to get in your car and disrupt your life and give up your lumber. The monetary incentive makes it easier. The higher price doesn’t just induce the hard-hearted to go. It induces the altruist as well.”

 

Video: A Price is a Signal Wrapped Up in an Incentive (Marginal Revolution University, 4:46 min)

“We take a look at how oil prices signal the scarcity of oil and the value of its alternative uses. Following up on our previous video, “I, Rose,” we show how the price system allows for people with dispersed knowledge and information about rose production to coordinate global economic activity. This global production of roses reveals how the price system is emergent, and not the product of human design.”