Sunday, 2 April 2017

The Price Of Everything, But The Value Of Nothing

A fellow on BBC Parliament last night was moaning that the price of diesel going down is bad for the planet. That depends, of course. If he understood price elasticity he wouldn’t have said such a thing. Basically, if a price is inelastic, then a change in that price will likely cause little change in demand, whereas if it’s elastic, it will*.

For example, if petrol and cigarettes increase in price, it won’t change consumers’ buying habits all that much because people need petrol for their cars and cigarettes for their addictions. This is price inelasticity. However, if goods like certain tinned foods, chocolate bars and cars go up in price, this can easily cause quite a change in demand, as consumers will likely switch to different tinned products, chocolate bars and cars. This is price elasticity.

Elasticity and inelasticity are observable factors of life: if your water provider tells you your bill is going up then you can’t really tell them you’re switching to something else other than water instead. Whereas if Cadbury’s put up their chocolate bars by 30% then you could simply switch to Nestle bars.

Once you grasp this basic econ 101 stuff it’s a lot easier to understand human behaviour in the market, and a lot easier to understand and predict how people will respond to incentives. When there are shortages, most people assume it is because there is a scarcity of supply. Sometimes there is, but to generalise here is an amateur mistake, because most shortages are caused by there being less of something than we want, which is not so much conditioned by its supply but by its price (think of Adam Smith's well known diamonds and water example - diamonds are in relatively short supply yet there is not a shortage of diamonds in the marketplace, and yet over 70% of the earth is water yet there are often water shortages).

So a shortage means that the price is lower than the point at which supply and demand are in equilibrium. This is sometimes caused by suppliers not adjusting prices quickly enough, but for the most part it is caused by governments, through regulation, taxes, subsidies or price controls.

I know so many people just take it for granted that when governments interfere in market prices it is for the good of the nation. But a rational, informed thinker understands that the price linked to supply and demand curves is what equals value, not because price is determined by value, but because quantity determines price, and amount consumed is the determiner of value. Equally, for the supplier, price equals cost, not because price is determined by cost, but because price determines quantity, which determines cost. The intersection of supply and demand curves is what gives us prices, and it tells us what people value.

But it's more than that, because this is not to be considered in isolation, it is linked in to every other transaction too. That is to say, every price directly affects every other price because the price of, say, apples, may well affect one's demand curve for, say, oranges or bananas, which may affect one's demand curve for, say, chocolate, coffee or bread - all of which affects sellers' prices and quantities (amount produced) too.

It's not unusual to see people forgetting this in relation to jobs, but indeed the same applies in the labour market too. The price of an input is equal to its marginal cost of production and its marginal revenue product, which is the resultant change in revenue for the employer as a result of the addition of one extra unit when all other factors are kept equal.

The quantity of the input sold is the quantity whereby the marginal cost of production is equal to the marginal revenue product (marginal cost = price = marginal value). In less formal terms that's just a fancy way of saying that if I own, say, a doughnut making business, and want to consider taking you on as an employee, I'll only do so if your wages equal the value of the additional doughnuts you produce. You should be able to imagine now, if you couldn't before, just how much harm price-fixing does here, not just to the job market, but to consumers that help create those jobs too.

One of the main ways that politicians fail the people they represent is by being blind or dismissive of all those things I mentioned above. By controlling the money supply, by increasing the nation's debt with irresponsible borrowing, by increasing the cost of living for the most struggling families, by dis-aligning supply and demand price signals, by overseeing wasteful misallocation of vital resources, and by making otherwise affordable things unaffordable, they press society's billions of revealed preferences under the thumb of their own nest-feathering, and in doing so, make society a place that is wholly unrecognisable from what it would look like if people got to spend their money exactly how they wished.

* As a formal rule, the elasticicity of a supply curve at a particular price is measured by the extent to which quantity increases (as a percentage) divided by the increase in price. On this point, beware of politicians, who very often make polices with almost total disregard to how many supply and demand curves are elastic when there is an effect on price or quantity.