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Sunday, May 22, 2016

Prices: How are they derived?

Bread $2.00/loaf. We see this at our local grocery store. This price sends a signal to us. If it does, what signal is it sending? It is obvious that the $2.00/ loaf is the signal, prima facie. Yet, there is more to this process.

Prices are signals to both parties in the free trade process. However, how are they derived?

Barter
In the past, free traders used barter to exchange goods. The "prices" of those goods were expressed in the other good that was needed by the seller. For example: If a seller of a cow needed two hens, the price would be two hens. 

Money

As barter was replaced with money, the unit of money represented the price.(e.g 1 hen= 2 gold coins) This made the process more efficient for both sellers and buyers on the transaction.  With the case of money, prices are stated in terms of money, as in this example, the number gold coins.  With money, we can carry it forward with currency, as the prices would be expressed in terms of the respective currency type. (e.g. USD, Euro, Pound, etc)

Price and Subjective Value

Money is a means to do multiple things. It helps maintain a level of recordkeeping or accounting of transactions, as we previously discussed since prices are presented in terms of money.  Money also is used to "store value". This concept of "storing value" is a curious one, since value is subjective. While this is true, the money used may not and does not measure all the value expressed in the transaction. However, we can see what things people  value over another based on the law of marginal utility. Hence, prices play an active role in helping the economic actor to evaluate his utility preferences. 

Prices, therefore, are spawned out of a need to attempt to quantify subjective value for the economic actor. As the actor is moving to improve his situation, he goes to acquire more "stuff". In this pursuit, he will make choices on the acquisition of "stuff" based on his preference ranking. Note: this preference ranking is dynamic, thus it is constantly changing.  

Conclusion

Prices act as a valuable tool in the free market process. They provide vital information to the economic actors. The primary purpose for prices is the attempt to project value in terms of the money displayed. While prices can not quantify the true value for the economic actors, it does provide a way for the actor the ability to prioritize his wants and needs accordingly. 

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