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Introduction to Price Theory, Part 3: Incentives and Information

February 27, 2012

Price changes provide both incentives and information to market participants. A price signals to participants how much others think a good is worth, tells people about how difficult it is to produce, and rewards entrepreneurs who can produce it for less. A high price signals that a good is relatively valuable to those buying it, and encourages suppliers who think they can undercut it to enter the market and compete. Those who provide the good at low cost will be rewarded by high profits. On the demand side, a high price encourages consumers to look for alternatives and to economize on their usage of the good. A low price signals to market participants that a good does not need to be conserved and can be used freely.

A price can communicate that there is a draught on the other side of the world, a financial crisis, a new fad diet, or any number of other factors instantly to buyers and sellers of goods, and simultaneously provide incentives for people to act efficiently in the face of the new information.

Never reason from a price change. Instead of beginning analysis by thinking about which way prices move, try to figure out whether it was a supply or demand shock and which way the curve shifted. This will avoid logical errors and circular reasoning.

“The ease of calculation provided by money, is thus not merely a device for lowering transactions costs relevant to deliberate search, … It represents a social arrangement with the ability to present existing overlooked opportunities in a form most easily recognized and noticed by spontaneous learners.” – Israel Kirzner

Demand Increases: Price Increases, Quantity Increases

Demand increases when some people decide that they want the good more, relative to other things they can buy. They are willing to pay more, so they bid up the price of the good. Suppliers get more money from selling the good, so they are incentivized to produce more. They can use the additional money to build more factories, hire more workers, or whatever they need to do to increase quantity. People whose demand did not change may decide not to buy the good at the higher price. They will voluntarily relinquish their claims on the good so that someone who is willing to pay more can buy it. The price signal encourages those with low demand to economize and substitute for other goods.

Demand Decrease: Price Decreases, Quantity Decreases

Demand decreases work the same way as increases, but reversed. Instead of being encouraged to sell more, sellers find their goods sitting on the shelves at the old prices. They must cut the price to sell their inventory, leading to layoffs and less capital investment in production. The workers and capital will eventually find new, more efficient uses for their time, perhaps producing something for which demand has increased. Keep in mind that microeconomy demand is relative demand. Absolute demand is assumed to always be high enough to use up all of the productive capacity of the economy.

Supply Increase: Price Decreases, Quantity Increases

A supply increase is when the good becomes lower cost to produce. Perhaps the natural resources used to produce the good became easier to get, or workers became more productive. Suppliers facing a reduction in price will pass some of the lower costs on to their consumers (even monopolies). Some consumers who didn’t buy the product before will now purchase it at the new lower price, leading to increases in quantity. Buyers don’t have to know what changed in order to react efficiently and immediately to the new supply curve.

Supply Decrease: Price Increases, Quantity Decreases

If a good becomes harder to produce, the supply curve will shift up and to the left. Sellers will not want to supply as much as before at the old price and will restrict output. The good will be more scarce and only those with relatively high demand will buy it at the new higher price.

Part 1 here.
Part 2 here.

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