PRICES (Social Science)

Prices are the rates at which goods and services are exchanged for other goods and services, or for money. In a monetized economy, the term price usually connotes the amount of money for which a good or service is purchased or sold. While in conventional usage, the term price is applied only to goods and services, in economic analysis, wages, interest rates, rents, and other money exchange rates for specialized services are also considered prices.

Prices have a critical coordinating role in a market economy. Ordinarily, an increase in a good’s price conveys the information that it has become scarcer relative to the demand for it, either because its supply has fallen or because the demand for it has risen. A higher price induces existing producers to supply more of the good, and it attracts new entrants into an industry, since it tends to be associated with a higher-than-normal profit margin. Conversely, a declining price leads to reduced supply. Economists see these reactions as being exactly what is required for social efficiency, since resources should be withdrawn from uses that are less valued and drawn into uses that people value more.

Economist and social theorist Friedrich Hayek (1899-1992) argued that prices convey information about "global" (or society-wide) conditions to "local" actors (such as business owners), thereby solving a core informational problem faced by a society when it attempts to decide how best to allocate scarce resources. Hayek argued that the compactness or one-dimensionality of prices and the fact that they arise spontaneously as byproducts of self-interested buying and selling activities makes them a uniquely economical way to coordinate society’s resource allocation process. In the "socialist calculation debate" of the 1940s, Hayek argued that it is impossible to solve the problem of efficiently allocating resources among productive activities in an economy of specialized producers without market-generated prices. During the middle decades of the twentieth century, the apparent economic viability of the Soviet Union and like economies was sometimes viewed as contradicting that claim; yet reform-minded economists in the socialist world asserted the validity of Hayek’s argument when political conditions allowed the matter to be discussed and their views ultimately prevailed.


Economic analysis distinguishes between nominal and real prices. The real price of a good is its price relative to the prices of other goods, while its nominal price is its price denominated in a currency the value of which may be changing over time. For example, if all nominal prices, including wages, were to double over a certain span of time, the real price of any given good would remain unchanged. The terminology reflects the idea that money is merely a medium of exchange without an intrinsic value of its own, and that what matters economically is therefore relative prices, including the purchasing power of people’s money incomes.

In practice, changes in a country’s price level can have real consequences. Inflations rarely affect all prices in perfect proportion. For this reason, and because of their asymmetric effect on, for instance, debtors versus creditors, they have significant distributional consequences. In a world of many countries and currencies, differences in rates of change in price levels affect international trade and payments. Unpredictable price changes increase risk, discouraging some investing and trading activities. Rapid price change can give rise to real costs, such as those associated with having to recalculate and reprice items frequently, the pressure to spend money as soon as it is earned, and the need to print and to carry large quantities of money.

Classical economists such as Adam Smith (17231790) distinguished between natural prices and market prices. While the terminology suggests that the "natural price" may have an underlying ethical quality, modern historians of economic thought generally understand the term to have been a reference to what would today be called a "long-run equilibrium price," that is, the price at which a normal or average rate of profit can be earned. This is the level toward which a good’s price will adjust in the long run, through expansion or contraction of output by current producers and through exit of old and entry of new producers into the market. The "market price" is simply the price at which a good is sold at any given point in time. Since changes in supply or demand are always occurring, market prices are the prices we actually observe, while natural or long-run equilibrium prices are idealized or theoretical indicators of long-run tendencies.

Neoclassical economic theory teaches that allowing prices to be governed by the forces of supply and demand is the best way to permit them to play their role of signaling scarcity and guiding the ongoing reallocation of resources to their most valued ends. When governments intervene by setting price floors or ceilings, by taxing the sale of some goods but not others, by imposing tariffs on imports, by subsidizing some producers, or by directly determining what prices can be charged, prices become "distorted" and can no longer be counted upon to steer resource allocation toward efficient uses. In an economy in which prices are significantly distorted or controlled in these ways, it remains possible in principle to calculate what prices "should" be, that is, what they would be if market forces were permitted to determine prices freely and exclusively. The true "scarcity-reflecting" prices thus calculated are referred to by economic theorists as shadow prices, and they play important roles both in theoretical analysis and in some practical policy exercises.

On closer inspection, however, unregulated prices are not always the ideal, even according to neoclassical economic theory. Monopolists can push prices above levels associated with normal profit rates and efficient supply. The market prices of goods whose production destroys unpriced resources, such as clean air and water, systematically understate their true cost to society. Government interventions, such as setting a maximum price for a monopolist, breaking up monopolies so that competition will bring down prices and increase supply, or taxing polluters to force them to internalize costs they might otherwise impose on society, can at least in principle improve upon unregulated outcomes, although knowing how a government will act in practice requires an understanding of a range of political and economic factors.

Scholars who compare economic systems of different types emphasize that prices play more than a scarcity-signaling role in an economy. Prices also determine the relative incomes of different groups of economic actors. For example, higher real wages may mean lower profits and hence a smaller income gap between wage versus profit earners. A higher ratio between the wages of more-educated or skilled and less-educated or skilled workers was associated with rising income inequality in industrialized economies during the last decades of the twentieth century. In the heyday of the Soviet Union and other planned economies, planners set the wages of urban workers and the prices paid to farmers for their produce at levels consistent with the proportions of consumption versus investment desired by the political authorities. In this way, they used control over wages and prices as a method of dictating high rates of capital formation. Prices also functioned as accounting aids in the centrally planned economies. Their existence allowed economic planners to monitor the fulfillment of plan targets through a system of indicators (money flows) parallel to but distinct from indicators of physical input and output.

Their impact on the distribution of wealth, for instance between sellers and buyers, also explains why prices attract ethical attention, as epitomized by medieval European discussions of the "just price." Sellers of a resource in plentiful supply, for example unskilled labor, cannot command high prices (wages) for their service under competitive conditions, resulting in their poverty in comparison with those selling a scarce resource—perhaps access to fertile land. Companies in the oil industry earning large profits in the wake of short-run supply shortfalls attract ethical and political attention because a higher price for transportation and heating fuel means poorer consumers and wealthier company owners. Governments sometimes try to prevent such transfers by fixing a maximum price. If the supply of the commodity in question is fixed, the price ceiling will cause demand to outstrip the available supply, which will then be "rationed" by some nonprice mechanism—perhaps willingness or ability to wait in line, perhaps rules governing who can purchase on which day of the week, or perhaps government issue of coupons in limited number. In some circumstances, rationing a scarce but crucial commodity may be preferable to letting market forces operate, but in eliminating the short-run windfall that would otherwise accrue to suppliers, it can also slow the expansion of output that would reduce the commodity’s scarcity in the long run.

Many governments set minimum wages, tax high incomes at steeper rates than low ones, or engage in other price-altering interventions in order to protect disadvantaged groups or moderate income inequalities. But governments face pressures from constituencies other than the poor, which also leads to price interventions. For example, tariffs preserve the profits of domestic producers at the expense of domestic consumers, and often also at the expense of forces promoting long-run competitiveness. The effect of prices on the distribution of income helps to explain a variety of government price-altering policies.

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