What’s in a price
Fri 16 Jul 2010 by Matt Nolan.

Prices are vexing things.   As a buyer it often feels like you’re being charged too much, as a seller it seems like people are unfairly trying to push your prices down, and finally as a government official you may think the price of something is just wrong.   Oft times it feels as if prices appear by magic, and as a result individuals and groups are comfortable complaining that prices should be higher, lower, or at least less volatile.   However, prices aren’t as magical as they first appear and trying to understand the process of pricing can help us get to grips with what good and bad government policies should look like.

The best way to look at prices is to strip back as many details as we can, and just focus on the core elements of price setting.   So as a starting point we can take someone that is interested in buying something and someone else who is selling that very product.   Think of it as a two-person version of Trademe.

In this case there is one good sitting around, one person who has the good (seller), and two people that value it in some way (the seller and the buyer).   What matters for trade between these people is the relative value they place on the good?   If the seller values the good more highly than the buyer, they will not trade.   But if the buyer values the good more than the seller, we know there will be some "price" which the buyer is willing to pay and the seller is willing to accept.   Trading in this case ensures that both individuals are better off, and the price that is set merely represents how the benefits from this trade are shared between the two individuals.

In this context, talking about the price being "wrong" makes little sense the price is merely some way for individuals to split the gains from their voluntary trade.

Now this is all well and good in the case where there is only a single buyer and seller, but what happens when this changes?   If we now open up Trademe to all of New Zealand, we have one seller for the good but a myriad of buyers.   In this case the buyers bid up the price, until only the individual who values it the most highly can buy it.   If this price is attractive enough, this may cause other sellers of the product to jump on Trademe in turn leading to further trade between sellers who want to sell and buyers who want to buy, albeit at a new lower price.

In this situation, a price is "wrong" if there is the potential for trade to create some benefit, but there is an impediment that either prevents trade from happening or makes the net outcome of the trade a bad thing.   There are four such situations where this is the case:

  • Excessive market power:   In this case, our seller on Trademe has found a way of preventing other sellers entering the site holding up the price for himself, but preventing other beneficial trade.
  • Externalities:   This is when the use or creation of a good impacts upon other parties who are not involved in the market transaction.   In the case of Trademe this could be related to the sale of a vuvuzela, the consumption of which would cause great harm to innocent bystanders at football games in this country.
  • Asymmetric information:   Our seller may be able to post a photo or two up on Trademe, but that isn’t really sufficient for the buyer to have as much information about the good as the seller.   If a product could have hard to observe good or bad qualities it is possible that some buyers and sellers may not trade, even though the buyer would truly value the good more than the seller.
  • Confusion regarding ownership:   In the Trademe case, a brother may be trying to sell his sisters favourite item of clothing.  If her property right over her piece of clothing is not protected, we may have a situation where the item is traded even though it shouldn’t be.

If one of these issues exists in the marketplace, then we might have a situation where government policy can help.  However, the goal of policy in this case is not to change the price per see, but to deal with an institutional impediment that is preventing value from being created.

So in the future, when an interest group or politician complains to you about prices, try and figure out what impediment they have in mind then you can clearly ask yourself if the policy they are trying to sell you makes sense.

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