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The Price System

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The Price System

The price system is a means of organizing economic activity. It does this by coordinating the decisions of consumers, producers, and owners of productive resources. Millions of economic agents who have no direct communication with each other are led by the price system to supply each other's wants. Every economic system has three functions. In a decentralized usually private enterprise economic system, the price mechanism is the instrument by which these functions are performed.

Prices are an expression of the consensus on the values of different things, and every society that permits exchanges among consumers has prices. Because prices are expressed in terms of a widely acceptable commodity, they permit a comparison of the comparative values of various commodities--if shoes are $15 per pair and bread 30 cents per loaf, a pair of shoes is worth 50 loaves of bread. The price of anything is its value in exchange for a commodity of wide acceptability, money.

A system of prices exists because individual prices are related to each other. If, for example, metal rods cost 40 cents a pound and the process of drawing a rod into wire costs 25 cents a pound, then, if the price of wire exceeds 65 cents, it will be profitable to produce wire; and if the price of wire falls below 65 cents, it will be ruinous to produce wire. Competition, therefore, will hold the price of wire about 25 cents per pound above that of rods. A variety of such economic forces ties the entire structure of prices together. One function of the price system is to determine what is to be produced and in what quantity. Even an ancient economy must choose between food and shelter, weapons and tools, priests and hunters. In a modern economy the potential variety of goods and services that may be produced is immense. Consider simply the 10,000 new book titles that are published each year or the hundreds of colors of paint or the thousands of styles of clothing that are produced--each of these actual collections being much smaller than modern technology permits.

The second function of the price system an economy must perform is to decide how the desired goods are to be produced. There is more than one way not only to skin a cow but also to grow wheat, train lawyers, refine petroleum, and transport baggage. The efficient production of goods requires that certain obvious rules be followed: no resource should be used in producing one thing when it could be producing something more valuable elsewhere; and each product should be made with the smallest possible amount of resources.

The third function of an economy is to determine who gets the product. Family A gets $5,000 worth of goods this year, family B five times as much--how is the division to be decided? The incomes of individuals are determined by the quantities of resources labor skills, capital in all its forms they own and the prices they receive for the use of these resources. Workers are incited by the price system to acquire new skills and to exercise them diligently, and families are encouraged to savings (capital accumulation) by the payment of interest or dividends. The inheritance of both personal ability and wealth also enter into the distribution of income.

Individuals must be distributed among occupations in such a way as to serve two basic purposes. First, the laborer must be placed where he is most productive. Second, the individual worker should be given an occupation that is congenial to him: since he will spend a large part of his life at work, it will be a better life if he can choose the type he prefers. The price of labor is the instrument by which workers are distributed among occupations: wages in rapidly growing occupations and rapidly growing parts of the nation are higher than in corresponding employment in declining occupations and areas. The choice of occupation involves, however, much more than simply a comparison of wage rates.

When we look at the changes that have swept our life over the past years, we see that less and less room is left for the government. It is not only private bread on our tables that we enjoy. People increasingly use private medicine, send children to private schools and hire private babysitters. In many cases, however, private property and private services exist in name only. Private health care services, for example, are subject to extensive price controls and ceilings. Many free prices are controlled indirectly, by various roundabout regulations. Government-imposed restrictions on market processes inhibit the development of a normal price system whereby prices are determined by market demand rather than calculation of costs. Thus, the market we have is in fact an administrative

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