Prices Are Everything

Pricing

Prices are the Key to Everything

The role of prices in human interaction is wildly misunderstood, and this misunderstanding is a cause of incredible suffering throughout the world.  If entrepreneurs want to meet broad human needs and facilitate flourishing rather than suffering, understanding the role of prices in an economy is almost unequalled in importance.  

The fallacy that most people believe is that prices are a characteristic of a product or service, something inherent like color or size or a measure of the labor put into it.  This is false and dangerous.

Instead, prices are the single most important piece of information about human needs that almost magically coordinates economic activity.  Prices are a signal about a specific need of specific buyers at a specific point in time.  Because prices are the central coordination mechanism for human action, interfering with them can only result in outcomes that are worse than allowing them to operate without interference.

For example, let’s say a widget maker finds that certain customers are currently willing to spend $20 to solve a need that the widget solves, but the widget can be made of steel or aluminum.  Let’s say another economic need is willing to pay $40 for the amount of steel required by the widget maker.  The widget maker might then choose aluminum as a material because steel is more urgently needed elsewhere.  This coordination didn’t require any “management” or human intervention of any kind, it simply relied on prices as the coordinating mechanism for scare resources to be allocated to their most valued current use.

As the “marginal revolution” in economics in the 1870’s also showed, the amount someone is willing to pay changes based on their circumstances and consumption.  A person might value a new toaster at $20, but they might value a second new toaster at only $4 because they now already have a toaster that meets their needs.  There is no “inherent” value in the toaster.  The value is simply what someone is willing to pay at that moment in time.

In a voluntary market exchange, both parties are better off.  The buyer values the toaster more than the $20 he or she gives up, and the seller values the $20 more than the toaster he or she gives up.  As long as transactions are voluntary, by definition both parties win.

The most controversial price is the price of labor.  But there is really no such thing as a price of “labor” in the general sense.  Instead, there is a price that someone is willing to pay for a specific type of labor at a specific time.  An individual may be able to perform many different services, each of which has a different price that others are willing to pay.  For example, Ted may be competent at spinal surgery, house painting, cooking, and babysitting.  Based on supply and demand, the current market pricing for his services might be $500/hour for surgery, $50/hour for house painting, $20/hour for cooking, and $10/hour for babysitting.  As supply and demand changes, these market prices will change.  And this doesn’t mean any particular individual will pay those prices.  It just means that there are some people who will choose to pay that and others who will choose not to pay that.

The main competing notion of pricing labor is the “Labor Theory of Value” endorsed by Marx and many current “progressive” economists that says labor of any kind is inherently valuable.  In the software industry, the famous book “The Lean Startup” represented an entire generation coming to terms with the failure of the Labor Theory of Value.  They had assumed that if they built software, it was valuable because they built it.  What they realized is that software nobody wants has zero value, regardless of how much time and energy they put into building it.  So they set about trying to figure out how to determine what customers value for meeting real human needs and then building software to meet that instead.  Proponents of The Lean Startup don’t necessarily understand the notion of prices described here, but they know deeply that building something nobody wants has no inherent value.

The other reason pricing labor is controversial is that people confuse it with the concept of “value” as a person.  They think that paying a surgeon $500 per hour and a babysitter $10 per hour means that the world thinks the surgeon is 50 times as valuable as the babysitter as a person.  This is ludicrous.  With the earlier example of “Ted”, it is clear that people are able to offer many different services at many different prices with none of them being tied to their “worth” as a human.  Labor pricing is simply the signaling the market uses to allocate scare resources.  Any interference in that signalling decreases the flourishing for everybody involved.

For entrepreneurs, the key takeaways are threefold:

First, understanding the role of prices is the first step toward understanding Human Action, and this will help you in all aspects of your business.

Second, be wary of temptations to control pricing on things that might not initially seem like pricing.  If you believe there is something “unfair” that involves compensation or allocation of any kind, do not fall into the trap of thinking you can engineer a fairer solution.  You cannot, and every effort you expend in attempting this will only result in negative side effects that dwarf the gains you hoped to engineer.  Instead, always let prices float naturally in the wilderness, and if you think something is unfair, your only moral option is to teach people to value something other than what they currently value.

Third, recognize that all prices currently have massive interference, and this represents opportunities for progress.  When governments attempt to engineer outcomes through controls on prices, whether it is on products, labor, interest rates, licensing, or other forms of centralized regulation, the only possible result is the privileging of specific small groups at the expense of everybody else and the widespread misallocation of scarce resources.  Don’t “optimize breadlines” (link).  Instead, architect foundational solutions that sidestep the centrally regulated markets to enable people to engage in the voluntary interactions they would otherwise do.  Every time you can liberate pricing from centralized control, you unlock enormous potential for human flourishing.

Prices are the key information that magically coordinate all human activity, and this notion deserves a degree of reverence and attention that few recognize today.

For more on how price discovery works, see here:  https://econ4business.com/business-videos/price-discovery/

More at E4B:

Peter Klein on Pricing:  https://hunterhastings.com/peter-klein-on-pricing/

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