For those of us in business, the setting of prices is a major function. In some businesses, prices are set and remain constant for long periods. In others, such as grocery or airlines, prices are in a constant state of flux. Because pricing is so much part of our daily concern, few of us take time to ponder the wider economic function of prices. It is a miracle that enables scarce economic resources to be allocated in an efficient manner. Let me explain.
The basis of any trading relationship is that we both benefit. When we implement an ERP System for a client, we get paid for our services and the client gains productive improvements to their business. It is the same if we buy a dozen eggs from Woolies. In both cases, prices need to be such that they facilitate the sale.
Price rises create the incentive for buyers and sellers to use economic resources efficiently.
Now if there is a scarcity – if there are too few consultants to meet the demand for ERP Systems, or too few eggs to meet the demand for breakfast – then both parties need to consider what to do. To begin, the price of consultants and eggs will rise. Consultants will realise their value and demand higher wages which will result in higher fees. The client will seek alternative ways to acquire an ERP System. Perhaps package software will replace custom software and fewer consultant hours will be required. Perhaps some people will replace their bacon and egg breakfast with cereal.
The price rises have transmitted information about the scarcity and encouraged positive economic reaction. Note that the cause of the price rise is immaterial. Neither the buyer nor the seller needs to know why there are insufficient consultants or eggs. It does not concern them that the consultant shortage is due to Universities focusing on training lawyers or that there has been an epidemic in the chicken industry. Prices efficiently transmit only the minimal information that the parties need to know.
The price rises have also created the incentive for buyers and sellers to use economic resources efficiently. When an item, or a component of manufacture, becomes scarce the parties will seek alternatives. In this way maximum benefit is gained from the scarce resource and other resources are brought into play. Alternatively, production may be increased, but this will invariably require more investment and the use of costlier resources. We can think of retraining graduates from other disciplines in IT, or importing eggs from elsewhere.
The third essential element in the mix is the principle of private property, that people own the results of their labour. Otherwise there is no incentive for them to respond to the shortage.
In 1958, Leonard E. Read wrote a delightful essay I, Pencil. He explained the collaboration of millions of people in the production of a simple pencil, in “the absence of a master mind, of anyone dictating or forcibly directing these countless actions, which bring me into being.” Read explained that the miracle of pricing is that it enables individuals to be part of a world-wide supply chain, each prospering by doing their bit without any need to control the work of others.