Treat Prices and Profits with Reverence

For such a supposedly free society, and for all the understanding we think we have achieved in economics, it is prices and profits, two cornerstones of the market process, that often seem to receive only scant respect, and usually a healthy dose of disdain.

As a whole we seem to give little regard to prices and profits (and losses), what they mean, how they come about, and what kind of information they convey to us.  It is unfortunate too that our political leaders, of all people, yield to none in their misunderstanding of the delicate importance of these essential signals in our economy.

There are a myriad of state-enforced price and profit controls in South Africa, and perhaps as many or more waiting to be legislated into existence.  For example, the Department of Health has the right to dictate ‘single exit prices’ and dispensing fees charged by drug makers, doctors and pharmacists, and just this past week dictated that these businesses may not increase their prices this year.  The state also imposes complete price controls on all petroleum and gas products within our borders, dictating exactly how much these products can be retailed for, setting specific wholesale and retail margins, and levying heavy fines on those caught in breach of these rules.  Similar examples abound.

We live within a deeply complex socio-economic reality.  Millions of individuals are each day engaged in the task of peacefully trading, cooperating, and competing with everyone else in order to stay alive and prosper.  In fact, when you think about it, it is remarkable that all of us simultaneously are able to pursue our personal (peaceful) goals, desires and whims without the social order regularly regressing into unmitigated chaos.  Such is the miracle of peaceful individual human action and spontaneous collective order.

This incredible coordinative function of the market is made possible by prices and profits.

Prices and profits in all manner of goods and services are the final, simple expression of billions of seemingly unconnected choices, preferences, and transactions, of resource availability, logistics, and fanciful fads, of negotiation, circumstance, and competition.

These are the signposts we need in a world of infinite complexity that make it possible for us to most accurately rank our consumption preferences, allocate our budgets, allocate capital to various productive processes, decide how much and how quickly to produce, and make countless other necessary decisions day in day out, year in year out.

In 1946 Henry Hazlitt said in his great book, Economics in One Lesson, that

“one function of profits… is to guide and channel the factors of production so as to apportion the relative output of thousands of different commodities in accordance with demand.”

Profits and losses are the function of relative input and output prices.  High profits to the producer of a particular good indicate that the realised final price is much higher than the factor input prices.  This is a signal to investors and producers to call forth more production of this good.  As they do this, the prices of the required inputs are bid up, while the retail price is bid down as more supply enters the marketplace, closing the gap between the two until profit falls to the point where investors and producers no longer wish to increase production.  For firms now to remain adequately profitable in order to replenish depreciating capital, they need to increase efficiencies.  As these efficiencies are copied by other producers so more production is called forth, and the final price falls even further. 

Can you see here how profits not only coordinate production decisions between a myriad of possible options, but also help allocate resources in such a way that final prices will actually fall?  In a counterintuitive twist of economic beauty, high profit is the very catalyst that causes goods to become cheaper, thereby best serving the interests of consumers.

Fixing any price by legislative decree is similar to pretending that a certain chemical result must remain the same even when the complex chemical process is altered.  By contriving the end-result and wishing into existence a pseudo-reality, we restrict society from adapting successfully to an ever-dynamic world, and we unknowingly tamper with infinite complexity, leading inevitably to consequences no central planner could ever hope to foresee, and often to a chain of chaos.  Price fixing takes a blunt axe to the visible expression of the unobservable, complex and essential processes that make our economic lives not only greatly enjoyable, but possible at all.

The sooner the state stops arbitrarily decreeing prices and profits, the sooner can South Africa begin concocting a truly powerful economic potion.

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