What is Price?
In my previous post, I talked about Interest Rates. But today, I bring you a cool concept that we take for granted. With this post, I want to explain to you:
- What price is
- How it is formed
- What information it offers
- Why it is so important to let it move as freely as possible for the benefit of society
So here we go. Let me define price as “The point of equilibrium between supply and demand”. Since this might be hard to grasp, let me break it down.
The Producer
Imagine that you are a farmer who grows potatoes and brings them to the market for sale. How much would you sell 1kg for? If you would like to succeed at making a profit, first, you should calculate how much it costs to grow 1kg. For that you have to count:
- The time invested in growing the potatoes
- The fertilizer
- The machinery you have purchased
- Other resources.
And now, after doing your numbers, you know what your cost is – 1 Є/kg for this example. And you can expect that your selling price would be that cost with some extra profit so that you can feed your family. We can also agree that the higher the price you sell your potatoes, the better for you.
The consumer
How much would you pay for 1kg? If you would like to make it right. First, you should calculate how much of your monthly budget you can spend. For that you have to discount from your monthly income:
- Utility bills
- Groceries
- Feeding the dog & kids (in that order :p )
- Other expenses
After doing your numbers, you know how much is the maximum you can afford to spend on potatoes that day, 2 Є/kg for this example. Ideally, if you get a price lower than that, you could save the rest for something else. So we can agree that the cheaper you buy the potatoes, the better for you and your family.
Notice here that both the consumer and the farmer have the same legit intentions. To make things better for themselves and their families. However, their ways to achieve it are opposed to each other.
At the market
Now at the market, the farmer and the customer haggle. The farmer will offer the highest prices, and the customer will offer the lowest ones. Having 3 possible situations, shown in the graph below:
- Area of no deal for the customer: If the farmer asks for more than 2 Є/kg, the customer will leave without potatoes to eat, and the farmer wouldn’t get to sell them.
- Area of no deal for the farmer: If the customer asks for less than 1 Є/kg the farmer will leave without being able to sell the potatoes, and the customer would not have potatoes to eat.
- Area of agreement: Farmer and customer agree on a price between 1Є/kg & 2 Є/kg living both happily ever after with their stomach and pockets full.
Notice that both of them want each other’s goods. The farmer needs money and the customer needs potatoes. So in the end, they are forced to reach an agreement and set a price that will benefit both of them. This is what price is (c), the equilibrium between supply (producer/farmer) and demand (customer).
What else does price tell and why is it so important that we let it be free?
Imagine that potatoes sell very high. The next farmers planting something in their soil will probably plant potatoes because they offer a promising profit. At some point, all those farmers will bring their potatoes to the market, and the prices will come down because there is suddenly a lot of them available.
Now the prices are low, and many farmers will be discouraged from growing potatoes because making a profit is much more difficult. Since farmers are no longer planting potatoes, we will start running out of them, causing prices to rise, encouraging farmers to plant potatoes again. This cycle repeats again and again and never ends. This results in the consumer having constant availability of goods at “relatively” stable prices.
Price concentrates all the information from the millions of those producer-consumer relationships. And it gives back one single number that everyone uses to make the best decisions possible for their benefit.
This is the reason why a free market is the most beneficial and efficient approach to running an economy. If the price is free, if the price is honest, everyone can manage their business and their economies efficiently. But, if the price is regulated, producers will not know when is the right moment to produce. They might produce too much, causing an excess of supply and a huge drop in prices, which would ruin them. Or they might produce very little, causing a shortage in the supply, which would ruin the consumer.
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