Free To Choose: A Personal Statement – Charter 1 The Power of the Market (3)

THE ROLE OF PRICES

The key insight of Adam Smith’s Wealth of Nations is mislead- ingly simple: if an exchange between two parties is voluntary, it will not take place unless both believe they will benefit from it.

Most economic fallacies derive from the neglect of this simple insight, from the tendency to assume that there is a fixed pie, that one party can gain only at the expense of another.

This key insight is obvious for a simple exchange between two individuals. It is far more difficult to understand how it can enable people living all over the world to cooperate to promote their separate interests.

The price system is the mechanism that performs this task with- out central direction, without requiring people to speak to one another or to like one another. When you buy your pencil or your daily bread, you don’t know whether the pencil was made or the wheat was grown by a white man or a black man, by a Chinese or an Indian. As a result, the price system enables people to co- operate peacefully in one phase of their life while each one goes about his own business in respect of everything else.

Adam Smith’s flash of genius was his recognition that the prices that emerged from voluntary transactions between buyers and sellers—for short, in a free market—could coordinate the activity of millions of people, each seeking his own interest, in such a way as to make everyone better off. It was a startling idea then, and it remains one today, that economic order can emerge as the unintended consequence of the actions of many people, each seeking his own interest.

The price system works so well, so efficiently, that we are not aware of it most of the time. We never realize how well it func- tions until it is prevented from functioning, and even then we seldom recognize the source of the trouble.

The long gasoline lines that suddenly emerged in 1974 after the OPEC oil embargo, and again in the spring and summer of 1979 after the revolution in Iran, are a striking recent example.

On both occasions there was a sharp disturbance in the supply of crude oil from abroad. But that did not lead to gasoline lines in Germany or Japan, which are wholly dependent on imported oil.

It led to long gasoline lines in the United States, even though we produce much of our own oil, for one reason and one reason only: because legislation, administered by a government agency, did not permit the price system to function. Prices in some areas were kept by command below the level that would have equated the amount of gasoline available at the gas stations to the amount consumers wanted to buy at that price. Supplies were allocated to different areas of the country by command, rather than in re- sponse to the pressures of demand as reflected in price. The result was surpluses in some areas and shortages plus long gasoline lines in others. The smooth operation of the price system—which for many decades had assured every consumer that he could buy gasoline at any of a large number of service stations at his con- venience and with a minimal wait—was replaced by bureaucratic improvisation.

Prices perform three functions in organizing economic activity: first, they transmit information; second, they provide an incentive to adopt those methods of production that are least costly and thereby use available resources for the most highly valued pur- poses; third, they determine who gets how much of the product— the distribution of income. These three functions are closely in- terrelated.