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A Pencil, An Apple, and a Price System

Jul 7, 2010 • Demand, Supply, and Markets, Economic Thinkers • 251 Views    No Comments

I suspect we take prices for granted. Please think for a moment about a $10 pair of shoes. As a consumer, that $10 price tag tells you that they are inexpensive and you won’t have to sacrifice very much to buy them. Correspondingly, seeing the same price, a shoe manufacturer might decide not to make them because profits would be minimal. 

Saying prices are the reason, in Free To Choose, economist Milton Friedman (1912-2006) tells us that thousands of people, who might hate each other if they ever met, cooperate to make a pencil. Its wood, he says, probably comes from the state of Washington where they must have used a saw which required steel, which needed iron ore. The lead is actually graphite which probably came from mines in South America. With rubber from Malaya, they made an eraser and still, yellow paint and glue were necessary.

Telling a similar story about the iPhone4, the NY Times described the worldwide cooperation that created it. While the phone is assembled in Shenzhen, China, according to a “teardown” analysis, its chips come from Germany, South Korea, and the U.S., a touch-screen module is from Taiwan, and the phone’s gyroscope is made by a Geneva based company. Also involved are Japanese, Italian, and French firms and every one of them probably has production facilities around the world.

Why do they cooperate? Dr. Friedman would have said that the reason is the price system.

The Economic Lesson

In a market economy, prices that freely respond to demand and supply provide information and motivation to buyers and sellers. The up and down movement of prices is called the price system.

By contrast, in the former Soviet Union, prices were set by government created committees. As a result, they did not convey information about efficiency on the supply side nor about quality on the demand side. Different suppliers were not encouraged by prices to interact nor to cater to consumers. Lacking a price system, the Soviet economy collapsed.

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