Wednesday, January 28, 2015

Prices, Information, and Coordination of Disparate Agents

In the last post, I listed 9 classes of objects that are pertinent to the study of economics. I stopped short of describing all 9 classes. Left are prices, expectations, and entrepreneurship. Each of these deserve their own post. Today I start with investigating prices, their place within economic analysis, and the system that they form.

As I mentioned previously, the price of a good is equal to the thing given up in order to attain it. If I give a dollar to a gas station attendant in exchange for a candy bar, the price that I pay is $1. However, not all prices are denominated in currency. Let’s say that the ladies and gents at a "free hugs" booth decide to start paying to give hugs because they have found zero willing participants at zero price. They set a price of 1 mini candy (you know… those candies that you give out during Halloween and put in the bowl at Christmas). The price paid implies an opportunity cost. We assume that the agent giving the hug expects this strategy to yield an outcome better than the next best outcome that could have been attained by some alternate use of the candy. This next best use may be consumption of the candy or its exchange for something. Or maybe one “hugger” would enjoy throwing out a candy onto the sidewalk just to see a passerby pick it up. This is known as opportunity cost. The agent imagines alternate uses for the object exchanged and places some value on these uses. We cannot know what these exact values are, or if they can even be represented by exact values. All we know is that the huggers prefer to use the candy to pay for a hug from a passerby compared to all other uses recognized by the hugger.

Typically in economics, when the word price is thrown around the author is referring to a market price. I might ask, “What is the price of one share of “Apple” stock?” For an answer, I check the stock price on the financial TV station or on a financial website. There is thought to be one price, at least during trading hours, as the vast majority of trades take place on the exchange. But does this hold for a commodity that can be bought or sold anywhere? Consider a scenario where two gas stations within proximity of one another charge different prices. Can we say that there is a single market price? Clearly these gas stations are charging different prices. How can we say that the law of one price [1] holds? Remember, price may be objectively represented by a value denominated in currency. Notice that the value of currency is not the only price paid by an agent. If he or she prefers to act out of habit, going to the cheaper gas station across the street may be a cost incurred in addition to the nominal price. Or maybe the agent prefers to not check prices. Whatever the reason, you are willing to incur the higher price. This does not disprove the law of one price as there must be some point at which the size of the discrepancy between prices motivates you to go the station with cheaper gas. The perceived cost of switching stations is equal to whatever that difference is to the agent and that perceived cost may not remain constant across time. Or put another way, if the agent is aware of the discrepancy and still shops at the more expensive station, the additional cost of purchasing gas from the apparently less expensive station, as perceived by the agent, is greater than the price discrepancy. This explanation can be made clear by an extreme case. Let’s say that one gas station decides to charge a dollar more than the other gas station across the street. While there may be some buyers that do not switch to the cheaper gas station, enough will switch as to promote a state where the station that charges a higher price lowers it and/or where the gas station charging the lower price will raise it. If neither of these occur, we can expect the station charging a dollar more for gas to go out of business. There are bounds within which notional prices are free to move as a result to subjective interpretations of price. In competitive markets, this range tends to be relatively narrow.

It is by this tendency toward convergence for prices of like goods that a constellation of relative prices can arise. Agents do not need prices to perfectly represent information about market conditions. Rather, price need only approximate market conditions in order for agents to make economic decisions that coalesce with one another. With this standard met, agents can interpret nominal prices of different goods as relative prices. In this way, an agents can compare the price of substitutes for inputs and outputs and make decisions about what products to make and what inputs to use. It is the consumer who provides information to producers concerning whether or not their choice of products to produce and inputs used to produce them were “correct”. Negative feedback – AKA, a growing stock of unsold goods or realized losses – helps the producer to decided whether or not to continue producing a particular good in a particular manner.

In the above case, prices convey information of which producers may have no knowledge. In what is perhaps his best known academic work, “The Use of Knowledge in Society”, Hayek tells a story about the price of tin to this effect:

Fundamentally, in a system in which the knowledge of the relevant facts is dispersed among many people, prices can act to coordinate separate actions of different people in the same way as subjective values help the individual to coordinate the parts of his plan. . . Assume that somewhere in the world a new opportunity for the use of some raw material, say, tin, has arisen, or that one of the sources of supply of tin has been eliminated. It does not matter for our purpose – and it is very significant that it does not matter – which of these two causes has made tin more scarce. All that the users of tin need to know is that some of the tin they consume is not more profitably employed elsewhere and that, in consequence, they must economize on tin. There is no need for the great majority of them even to know where the more urgent need has arisen [emphasis mine], or in favor of what other needs they ought to husband the supply. If only some of them know directly of the new demand, and switch resources over to it, and if the people who are aware of the new gap thus created in turn fill it from still other sources, the effect will rapidly spread throughout the whole economic system and influence not only all the uses of tin, but also its substitutes and the substitutes of these substitutes, the supply of all things made of tin, and their substitutes and so on.; and all this without the great majority of those instrumental in bringing about these substitutions knowing anything at all about the original cause. The whole acts as one market, not because any of its members survey the whole field, but because their limited individual fields of vision sufficiently overlap so that through many intermediaries the relevant information is communicated to all. (1945)

It is by this process that social economies appear to be auto-poetic, or self-organizing. Neither of these is too strong of a term to describe markets where autonomous agents are free to make and enact plans and engage in a process of trial-and-error where they bear the costs – and benefits – of their actions. It is the ability of agents to organize their plans in accordance with current relative prices and expectations of relative prices that allow markets to function. Thus the price system is “not the product of [any single] human design and … the people guided by it usually do not know why they are made to do what they do (Hayek 1945).” Of course, not all social institutions can be defined within this paradigm, nor do markets exist in isolation of political influence. These are interesting and important arrangements to analyze, but they are outside of the purview of a pure analysis of the price system.

[1] The “law of one price” is a concept that falls out of classical economics where, in the long-run, price discrepancies for like goods in different markets will be eliminated by arbitrageurs who buy low and sell high. The profit motive guides the market toward a single price, though we cannot say what that exact price is any given moment. In the modern world, financial markets tend to quicken this process.


  1. Thanks Gene. All to often, the subjective element is lost. There is no such thing as a price, in the pure sense of the word, without an agent to pay it. This concept is lost when one's definition of price is the observed nominal price.