Volume 1, Episode 12
Prices send signals and provide incentives for buyers and sellers in ways you possibly never thought about. In a market economy, price signals prevent massive shortages and ensure that consumer wants are largely satisfied. In this episode of the Economic Lowdown Podcast Series, hear how price signals from gas prices influence decision-making for both a father of three and a production supervisor for an oil refinery. Do you see price signals influencing decisions in your life?
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Communication is important in every aspect of life. We communicate in a variety of ways, such as through verbal speech, text messages, and sign language. Even honking a car horn can be an effective form of communication. Communication within an economy is also very important.
Think about this: The United States has no centralized government planning agency to organize the economy. While government does have a role in the economy, no centralized agency gives orders to private firms to ensure that sufficient quantities of all goods and services are available to consumers. Do you ever fear that your local gas station might run out of gasoline to fill your tank? Or, have you ever gone to get a hamburger at your favorite restaurant only to be told they’re out of burgers? Probably not.
With no central agency in charge, how do firms know how much to produce, where to deliver goods and services, and what prices to charge consumers? Likewise, with no central agency to tell consumers how much to consume, where to buy, or what prices to pay, how can we be sure there won’t be massive shortages or surpluses, or that we won’t be charged too much?
Well, in a market economy such as we have in the United States, prices send signals and provide incentives for buyers and sellers in ways you possibly never thought about.
Imagine that a natural disaster results in a shortage of gasoline.
A shortage is a situation in which the quantity demanded of a product is greater than the quantity supplied. In a government-run economic system, the government would most likely attempt to increase the quantity supplied by dictating that firms produce more gasoline. The government would also likely restrict the quantity that consumers could buy. This would take an extensive bureaucracy of people to provide a massive amount of information, to plan and direct resources, and enforce the new rules. Even then, the amount of gasoline produced might not match what consumers really wanted or what firms could produce efficiently. This kind of mismatch was an ongoing problem in command or centrally planned economies, such as the former Soviet Union, where government planning agencies tried, and failed, to effectively manage the economy.
In a market-based economic system like our own, the market, and not the government, would determine the price of gasoline and the quantity produced and consumed after a natural disaster. Price signals communicate in such a way that prevents massive shortages and surpluses and ensures that consumer wants are largely satisfied. The actual price of the good or service—in this case gasoline—provides an incentive to buyers and sellers. For example, after a natural disaster, the supply disruption would cause the price of gasoline to rise. Just as a traffic light sends signals to drivers coming from many directions, allowing for a smooth flow of traffic, higher gasoline prices would signal to buyers to reduce their consumption and to sellers to increase their production. And both would have an incentive to do so. In this way, price signals allow markets to function efficiently under many kinds of conditions.
Let’s consider our example a little further. Next you’ll hear from two individuals who have made decisions based on price signals: Mark Hansen, a stay-at-home father of three and Patricia Finn, a production supervisor at a local oil refinery. Mark, let’s start with you.
Sure. Thanks, Scott. Hi everyone, I’m Mark Hansen. My family is on the go and on a tight budget, and I’m always looking for ways to save money—in fact, my kids say that I pinch pennies so hard they can hear Abraham Lincoln scream. They think that’s pretty funny, but what’s not funny are today’s gas prices. We live in a rural area outside of town and have to drive to get just about anywhere, and we seem to burn through gas as quickly as we pump it. At first we simply tried to avoid unnecessary trips, but with three school-aged kids and active social lives, this has proved difficult if not impossible. Carpooling has helped some, but gas prices are so high, we must do even more. We’re currently shopping around for a more fuel efficient car—maybe one of those fancy hybrid numbers—and we’re even kicking around the idea of moving closer to town so my wife can be closer to the office, and our kids can be closer to school. So for us, high prices sent a signal that my family and I heard loud and clear—reduce fuel consumption to reduce our expenses!
Great, thanks for sharing. Patricia, how about you? What kind of decisions do you make based on price signals?
You can call me Pat, and I use price signals to guide my decision-making at the refinery. You see, we’re part of a distribution chain that supplies gasoline and other refined fuel products throughout the quad-State area. As you may know, gas prices vary from location to location, and higher prices are an incentive from me to be creative with distribution. For instance, if a flood or other natural disaster were to cause a spike in gasoline prices in the affected area, in the short run, I might divert gasoline from areas with lower prices to the area with higher priced gasoline.
Scott: So, Pat, you use price signals to help prioritize distribution. What about production?
Patricia Finn: Well, if prices were to remain high for an extended period, I’d add another shift at the plant and increase production. It’s worth pointing out that when oil and gas prices are low, we extract oil from low-cost sources. As prices rise, however, we’re more likely to extract oil from higher-cost sources, too. So, higher prices make it profitable to expand production. Also, at higher prices, it becomes more feasible to invest in new technology and equipment that will allow us to increase production. For example, as oil prices have risen and technology has improved, it‘s become profitable to extract oil from shale formations in the northern plains of the United States and oil sands of Canada.
Interesting. Thanks, Pat.
You’re quite welcome.
In fact, just about every consumer and business will respond to price signals.
Here’s another way to think about price signals. Say you have your own lawn mowing business and find that consumers are willing to pay $20 for each lawn mowed. You mow four lawns per weekend. But, what if consumers were suddenly willing to pay $30 per lawn? The higher price signals that you could make more money if you expand your business. You’d likely give up time with friends to mow another two lawns. Or, if you believed the price increase would be permanent, you might decide to invest in a new, bigger lawn mower that allows you to mow lawns in half the time. In this way, the higher price created an incentive for you—the producer—to increase the quantity of lawns mowed.
So, higher prices send a signal to buyers to reduce their consumption and a signal to sellers to increase their production. Both buyers and sellers have an economic incentive to do so. These market reactions ensure that shortages either do not occur or are short lived.
Firms that produce goods and services are constantly seeking out buyers willing to pay the highest price. But what keeps firms from simply charging higher and higher prices, what some might call price gouging? Well, in markets with many producers, firms must compete for buyers’ dollars. So, firms have an incentive to price their goods at a level that is attractive to consumers. If a firm tries to charge a price that’s too high, its buyers will simply shop elsewhere. That firm will find itself with few buyers and subsequently reduce its price to attract more consumers. In fact, firms are most successful when they offer consumers a good or service that is a better value than the same good or service provided by a competitor. Such a competitive market ensures that the market price of a good or service closely reflects the cost of producing that good or service.
A competitive market system rewards firms that are the most successful at satisfying consumers. This is called "consumer sovereignty."
Stated differently, consumer sovereignty means that consumers determine what is produced in the economy. While this seems counterintuitive, firms are most successful when they produce what consumers want to buy. Think of dollars like ballots: Each dollar a consumer spends is like casting a vote for what producers should produce. As consumers shift their purchasing decisions, producers must shift their production decisions to earn those dollars―or votes. Think about this: For centuries the slide rule was used by mathematicians to perform a variety of calculations. Have you ever used one? Probably not. The development of the electronic calculator in the 1970s made the slide rule obsolete. So, as consumers shifted from buying slide rules to electronic calculators, firms that produced slide rules had to shift to producing something else or go out of business. In this case, consumers determined what would be produced by voting with their dollars.
Muffled Price Signals
Although price signals are effective in preventing shortages and surpluses, they do not eliminate the pain of paying higher prices. At times, governments may try to ease the pain of high prices by imposing price controls. One such control is called a price ceiling. When imposed, a price ceiling prevents a price from rising beyond a certain level. So, for example, if the market price of gasoline reached six dollars per gallon, the government might forbid further increases. Although this might sound like good news to consumers, price controls tend to distort—or muffle—the price signal, causing it to fall short of its intended message. For example, if gas prices were not allowed to rise to their actual market price, consumers would not reduce their consumption as much as they should because their behavior would be driven by the artificially lower price. They would not have the incentive to reduce consumption. Likewise, producers would not increase production as much as they should because they would be responding to the artificially lower price. They would not have the incentive to increase production. In this way, under price controls, the price signal results in a shortage that would not occur had the price been allowed to rise to a level determined by the market.
Communication is essential in a well-functioning society, including in a well-functioning economy. In a market-based economic system, price signals help prevent shortages and surpluses. All of this happens without the need for government intervention and generally ensures that consumer wants are largely satisfied.
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