In the last post, we explored the question of whether we should view social and economic problems from the perspective of the collective or the individual. I argued that any interpretation of complex social phenomena must consider the individual if it is to have any explanatory power. By advocating for keeping our eye on the individual, am I suggesting that collectives may be dispensed with altogether? Absolutely not.
Collectives provide society many benefits that individuals cannot possibly achieve on their own. So how do we actually understand vast and complex social phenomena through the lens of the individual? We considered the necessity of aggregating up from the individual perspective to the collective. One example of a useful collective, in the narrow economic sense, is a market. And one way to aggregate up from the individual to the market is via prices.
As I stated in the last post, collectives are best understood as groups of individuals, for only individuals are capable of action. Broadly, this aggregation occurs through a multitude of inter-actions of individuals. In fact, collectives can be thought of as not just groups of individual actions, but as collections of many interactions. Consider the example of a market for a good or service. No one individual ever possesses all of the answers to solve the problem of producing and distributing the good or service, not even the smartest computer! We need the collective, and that is where the market comes in.
The defining characteristic of a market is prices. Markets function through the formation and subsequent movement of prices. So what are prices? Prices are information. More specifically, they represent information particular to the local circumstances of time and place that allow markets to function.
Leonard E. Reed famously described the information necessary for markets to work as the little “bits of know-how” that only exist in individual minds. He borrowed this idea from another economist named Frederick Hayek, who said that
“The peculiar character of the problem of a rational economic order is determined precisely by the fact that the knowledge of the circumstances of which we must make use never exists in concentrated or integrated form but solely as the dispersed bit of incomplete and frequently contradictory knowledge which all the separate individuals possess.” (‘The Use of Knowledge in Society’, p.1)
Hayek explained that the fundamental problem that markets need to solve is not mere resource allocation. Rather, markets address the deeper and more difficult problem of the “utilization of knowledge” – how key information is utilized when it can only ever be partially known by many individuals. He gave us the groundbreaking insight that the knowledge necessary for markets to function is dispersed among individuals.
“It is rather a problem of how to secure the best use of resource known to any of the member of society, for ends whose relative importance only these individuals know.” (‘The Use of Knowledge in Society’, p.1-2)
So what is the link between individual actions, or groups of interactions, and prices?
At their most fundamental level, prices are first derived from the voluntary exchange that takes place between two individuals. Another name for this voluntary exchange is trade. A trade takes place when each individual possesses a good or service that the other wants or needs, and each individual would benefit from trading their good or service for the other. The trade is voluntary and mutually beneficial. When this occurs, a price emerges.
Let’s say I wanted to bake a cake, and my friend wanted to make an omelet. I have lots of eggs, but no sugar. My friend has lots of sugar, but no eggs. I agree to give her half a dozen eggs in exchange for two cups of sugar. Now we both have sugar and eggs, and we both are better off. The price of each good exchanged is the ratio between them. In this case, the price of one cup of sugar is three eggs, and the price of one egg is one-third of a cup of sugar. Understanding these ratios is key to understanding the emergence of currency, which is simply an easier and more efficient method of executing trades and creating value through voluntary exchange.
Prices are negotiable and flexible. They are never static. Because they arise from voluntary exchanges, they are mutually beneficial. If I was in dire need of sugar, I might be willing to give up twelve eggs instead of six for those two cups of sugar. The price of one cup of sugar would therefore rise from three eggs to six, and the price of eggs would fall from one-third cup to one-sixth cup per egg. Alternatively, if my friend was short on sugar, she might only be willing to give up half a cup for six eggs instead of two cups. The price of sugar would rise from three eggs per cup to twelve, and the price of eggs would fall from one-third cup to one-twelfth cup per egg.
In sum, prices are information about the relative scarcities of various goods across a vast array of circumstances, places, and human preferences. Through vast collections of interactions, prices coordinate the little bits of know-how that exist in individual heads to coordinate the exchange that takes place within a market.
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