The Role of Prices | Basic Economics by Thomas Sowell | Ch. 2

In this post, I'll be talking about the chapter 2 of Thomas Sowell's book, Basic Economics. If you want to see my summary and thoughts on the first chapter, go here. If you want to see why I'm doing this series at all, please go here.

Starting in the second chapter, Sowell begins Part 1 of the entire book, talking about prices and markets in economies. Here, he begins with the discussion of the role that prices have in an economy.

As before, I'll be giving a general overview, and then my thoughts and perspectives, especially through the lens of cryptocurrency, will follow.



The chapter opens with the question: how does an economy designate the scarce resources we discussed to their appropriate place in society, given their variety of uses?

A part of this has to do with the different types of economies that exist, including feudal economy, communist economies, and free market economies. But the most important thing that helps distribute these resources is PRICES. This is where we begin to understand why scarcity (or what I term limited access) matters so much.

Here is the example from the book: there are number of beachfront properties in the world. However, the number of people who desire to live in these beachfront properties is vastly greater than those available for those people to live comfortably. Due to this fact, the sellers of these properties will mark up the prices, because some people are willing to pay more to get what they want. Thus, prices serve as a way to indicate to consumers the desirability of a product or asset.

But suppose the government comes in and declares that all beachfront properties are a universal right, and begins to place caps on the prices for selling these properties. Such a thing could happen (and has, historically), but doing so would not actually change the issue: that there are more people who desire these properties than there are properties for them. Enforcing rules like this wouldn't change the fact that only a few people could be able to live in these properties at a time.

Furthermore, prices also tell the sellers whether the good or service they are selling is desirable. If someone creates a product and markets it, and finds that few people are buying it, they have a couple different options. First, they can stop producing it, if they truly believe what they are offering isn't wanted at all. But more likely, they can decrease the price of their product, as long as that price is still more than what it cost to produce.

And thus, this kind of free market is actually a profit-and-loss system. This is because no one knows what consumers want, but we can gauge consumer interest by selling products and services, and see which ones fit, and which ones don't.

Prices, Costs, and Other Consequences

All of this lets us understand the various aspects in which price helps dictate how an economy flows.

People don't want just one thing, but desire to have a number of different things. These different numbers of things often take the same raw materials to make. For example, cheese, yogurt, and ice cream all make use of milk. Whether that milk is used for cheese or yogurt or ice cream is determined by which ones are more popularly bought or sold.

In this way, prices allow individual producers to gauge what is desired by what is being bought and sold. As producers see a particular item doing well, they are able to increase production in that item, and decrease production in others that aren't doing as well. This allows the producers to continue to make a sustainable living by serving the lives of others. As Sowell says in the book:

The real cost of anything is still its value in alternative uses

In economies that are more authoritarian, where prices aren't allowed to determine value, and instead the government tries to determine what their people want, there is often inevitable disaster, because these governments have no idea what millions and millions of people will actually want.

One example given is the Soviet Union, which ran under a communist system. Despite having virtually no lack of resources (since the Russian motherland is actually quite rich in natural resources), the Soviet Union's planned economy failed spectacularly. The government bought certain products wholesale, which then went into abandoned warehouses, because those products weren't in demand. The ones that were in demand were soon sold out, and the infamous bread-lines were formed.

By not understanding that resources were scarce and had alternative uses, the Soviet government made their resource-rich country extraordinarily poor. And these disasters have been repeated with multiple countries and nations around the world, as given in the chapter. Sowell points out:

When people try to quantify a country's “need” for this or that product or service, they are ignoring the fact that there is no fixed or objective “need.”

A problem with the perception of prices—that high prices are a sign of greed, and not a reflection of true value. But this belief rests on two false assumptions. First, that buyers don't care about prices, and will buy at any high price. This is obviously untrue, as most people will buy at the lowest price for what they perceive as a good product. The second false assumption is that producers can set high prices with no consequences. This is also untrue, since competitors, knowing that buyers prefer lower prices, could immediately jump to sell an in-demand product or service to serve these buyers with what they want at a lower cost. Providing, of course, that the lower price still makes a profit.

There's a great example given in the book. Suppose a natural disaster happens which wipes out a large residential area. Those who survived will now be looking for temporary housing in places like hotels. Oftentimes, those hotels will increase their rooming prices. This is often looked at as a greedy ploy, taking advantage of people in poverty. However, as Sowell points out, which I will quote completely here, this is not really the case:

“Regardless of what hotel owners charge, a sudden and widespread destruction of housing in a given area means that there may be not nearly enough hotel rooms for all the displaced people to get the kinds of accommodations they would like. If prices had remained at their previous levels after the hurricane, a family of four might well rent two rooms-one for the parents and one for the children. But when hotel prices shoot up well beyond their usual . level, all four family members may crowd into one room, in order to save money, leaving the other room for other people who have likewise lost their homes and are equally in need of shelter. The more stringent scarcity of housing in the wake of a widespread destruction of homes is inherent, even if temporary, and prices merely reflect that underlying reality. If the government were to impose price controls under these conditions, then those who happened to get to the hotels first would take up more space and leave more late comers without a place to sleep indoors in that community.”

In this way, prices actually compel competition in areas which monopolistic entities like governments are slow to do. This is evident in third world countries, where humanitarian efforts are often mediated through local governments. However, these countries rarely rise out of their humanitarian crises, since governments want to appear benevolent and safe, and so take precautions to bring the products to the people. This actually slows their ability to help, thus making people suffer and starve.

But a 'greedy' corporation will often sideline this appearance in order to get food to the people that need it as fast as possible, since speed will determine their profit. That speed, especially in humanitarian crises, is of the essence.

My Thoughts

Competition is Good

I have long thought about the differences between businesses, non-profits, and government entities, and I think this chapter really lays out a great case for free-market enterprise being a far more benevolent entity than the latter two. While we often think non-profits and governments, being supposedly geared towards safety and security, as well as generosity in the case of non-profits, are two examples of good things in society, as Sowell points out, the opposite is often, in fact, true.

We can't underestimate the beneficial impact of competition in any scenario of society. I've written on this before in a review on Walter Scheidel's book, Escape from Rome: The Failure of Empire and the Road to Prosperity, but even history itself attests to the valuable power of competition and decentralization.

The scenarios presented demonstrate that putting caps on these products and services (e.g. rent control) has an adverse effect on the economy. Because prices are meant to show consumers the desirability of a product or service, putting price limits can deceive a person into believing false things about both the availability and the quality of that product or service. If all the peanut butter in the grocery store cost the same, how will you know which one you should get? You might as well have only one peanut butter product for everyone. But that doesn't tell you whether the peanut butter you're getting is actually what you want.

Instead, when competition and free market is allowed to thrive, we get to choose what we want, and when we want it. We might even get the lesser peanut butter sometimes, if it saves us money. But we might sometimes get the more expensive, if we're not strapped on cash.

There's another side to it as well. Instead of a price cap, let's say there's a price minimum. A similar thing happens with things like minimum wage (we can think of wage in this case as the minimum an employer would pay to have the service of an employee). By setting a minimum, we now no longer know the minimum quality of the good or service being offered. Is the service being offered really worth $15.00 per hour? If not (which is often the case), then someone will need to be let go in order to keep the business running. And thus, minimum wage actually increases joblessness, and then poverty, rather than helps the very people it was meant to reach. We can think of price minimums in the same way.

Of course, this isn't to say that governments or non-profit organizations don't have benevolent aspects to them. Rather, it is an effort to reconsider what benevolence is, and recognition of how competition in business can actually much better do the very things for which we often rely on in other entities.

The Competitive Landscape of Crypto

The current landscape of crypto is filled with thousands of ideas and companies trying to get in on the craze that potentially will change the way we look at economics and money forever. Each of these companies are attempting to out-do others in both tech as well as demographical reach. And each have various approaches to how it's going to happen.

For example, let's take a look at the world of DeFi. Currently, there are services which are more-or-less completely decentralized, like Compound and Maker. These systems are governed, not by a company, but by any people who are invested into the various governance coins which power these systems. On the other hand, we have services like Celsius Network and Nexo. These, I call SemiFi, because they're only participating in using decentralized finance, but operate as traditional centralized entities.

Time will tell which approach is better, but it's interesting to me that the completely decentralized systems offer quite volatile interest rates for suppliers that range from 0.01% to almost 50%, depending on the borrowing rate of users. There's no predictive measure to know when a certain coin in these services will have a high rate of interest, other than seeing the demand for its borrowing after it has already started.

On the other hand, SemiFi services, while their rates still fluctuate, offer much more stable rates across weeks and months at a time, sometimes much greater than that of DeFi, although never gaining quite the same immense rates at the highest extremes. These services also have much more limitations in the types of coins they offer interest on.

This comparative example is exactly described by Sowell. In SemiFi, where security and safety reign supreme, the coins offered aren't the new and the best. Instead, they're often the most popular, or the deemed the safest or oldest (e.g. Bitcoin). But for those that want a little more risk and are into the newest coins, true decentralized platforms are often first to offer them on their platforms.

I hope this has been helpful and informative. I'll see you in the next chapter!