Economics Part 3: Prices effectiveness

Prices are affected by two things: Supply and Demand. When the supply of a good is high prices tend to be lower. When supply is low, prices tend to be higher. When our demand for a good is high, prices tend to be high. When our demand for a good is low, the price is also low.

The benefit is that goods are allocated to their most valued uses. When our tastes in goods change from good A to good B, the price of B rises momentarily and thus resources are allocated or moved towards the production of B. This means the good that we want more, is supplied quicker. That is why innovation takes place in capitalist, price-coordinated economies quicker than socialist, government ran economies. Even more important is when supply is affected.

When a natural disaster hits a location, the supply is obviously affected by being destroyed and thus lowered. This then leads to a raising of prices. This rise in price leads producers to want to take advantage of this profit opportunity so they transfer or allocate resources to that area because this is where they are most valued at this time. The first companies to arrive there make generous profits. This is the incentive to arrive so quickly. That is why people arrived in New Orleans within hours of Hurricane Katrina taking place. When more and more companies arrive, the supply rises back up, and with all the competition, prices begin to fall again.

We can see that in a price coordinated economy, goods are effectively moved to their most valued areas. This is why our standard of living is so much better than most of the rest of the world.

Next post will discuss what happens when government puts price controls in place and thus not allow prices to freely function or change.