WHY ARE PRICES SO IMPORTANT?

What I learned from “The Use of Knowledge In Society” by Freidrich Hayek

TLDR: Prices give us nearly perfect knowledge about how to spend our most valuable resources.

When I was in high school, my friend Peter decided to start a small hustle selling starburst to our classmates for $1 a piece. He knew that the closest gas station sold starburst for $1.50 and that they were a favorite snack at the school. Peter figured out that he could buy a pack of 60 starburst for $30 and turn a 50% profit off each pack. He ran this business for a few months before he ran into two walls. First, the school started to crack down on the business claiming it was solicitation and threatening Peter with suspension if he continued to sell. This forced Peter to be more creative and sly with his business, but it did not stop him. The second wall came when the wholesaler raised the price of the 60 pack of starburst. Peter could still turn a profit, but he did not have as much incentive to deal with all the hassle. So for a while, he stopped.

Later that semester, the school began to stock the vending machines with $1 packs of starburst. Whether it was a coincidence or opportunism, the school took over Peter’s business. This story may be starting to sound like the cliche about the oppression of “the man,” but it's actually a story about the triumph of the entrepreneur. While the school was stocking its vending machines, Peter was planning his next hustle. He knew from his first business that starburst sales were slowing down. His classmates were fickle and the hype of the $1 starburst was waning, not to mention the increase in price. Peter found that he could buy packs of 24 mamba for $10 and sell them for the same $1 that he sold the starburst. Higher profits! So Peter continued to hustle.

If our school would’ve discovered Peter’s new business plan and once again started to sell the same product at the same price, it would not have mattered to Peter’s business. The school could not move as fast as Peter could. They did not have and could not gain the informational edge that allowed Peter to adapt to the business environment so effectively. The highschool was a central authority. They could never dream of running Peter’s business as profitably as he could.

At the extremes, there are only two ways that people are able to organize. There can be a central authority that makes important decisions for everyone, or you can leave those decisions in the hands of the individual. They are disparate methods of organizations, but at each extreme the same problem exists. How can you move information so that the decision makers are capable of making informed decisions?

Fredidrich Hayek in “The Use of Knowledge In Society,” explains that the problem of having central planning and central authorities is that they are incapable of aggregating the qualitative information that individuals gain through unique experiences. Aggregating that knowledge is an impossible task. The highschool would never be able to gain Peter’s individual qualitative knowledge about his classmates, about student preferences, and about the school’s own economy.

Hayek believes that because you and I have asymmetric information that is distinct and impossible to aggregate we, as individuals, will always be better decision makers than a central authority, government or bank. Even so, there is still the problem of how to get information to the individual decision makers. Because everyone has a unique perspective it is impossible for any one individual to have perfect knowledge. We require a medium that allows us to provide each other with our asymmetric information and receive information from others. Price is that medium.

As it turns out the wholesaler that Peter was purchasing from had to increase their prices because they themselves were experiencing an increase in the price from the manufacturer. The manufacturer had to increase their prices because they saw an increase in the cost of sugar. Sugar prices were increasing because of a persistent drought in India. But, Peter did not need to know any of this in order to make an informed decision about his business. He only needed to know that prices went up.

On the surface this seems like an obvious point, but when you start to dig deeper and recognize that everything is priced, the economy opens up and the messages being sent by the market become much clearer.