8.3 Prices Are Signals, Incentives, and Information
Organizing our economy is a colossal logistical challenge. Each business needs access to the right inputs. Those inputs need to arrive at the right time. They need to be combined in just the right way to be transformed into useful products. And those products need to go to the right people. Markets do an extraordinary job of organizing all of this. But how?
The answer is prices. They play three central roles. First, a price is a rapid-fire signal, sending messages that are heard around the globe. Second, a price is an incentive, inducing people to make better choices. And third, prices aggregate information, incorporating the judgments that motivate the thousands of buying and selling decisions that push the price up or down. Prices guide nearly every decision we make, helping to organize and coordinate economic activity.
Role One: A Price Is a Signal
It’s pronounced “keen-wah,” and it’s delicious.
Quinoa has been called the “miracle grain of the Andes.” Its small rice-like seeds are grown almost exclusively on the plains of the Andes mountains in Peru and Bolivia, and it’s so nutritious that NASA feeds it to astronauts. In recent years, health-conscious Westerners have discovered quinoa and what was considered peasant food for centuries is now on the menu at healthy salad places, trendy cafés, and fancy restaurants. Stop by any grocery store and you’ll find quinoa salads, quinoa breakfast cereals, quinoa granola bars, quinoa crackers, and even quinoa-based mac and cheese.
The recent quinoa fad is the biggest change to ever hit this market. But it’s all happening far away from the farmers who are high in the Andes mountains, cut off from news about the rest of the world. How do they learn about food trends in the United States? And how do American gourmands communicate their new love for quinoa to the farmers in Peru and Bolivia?
They communicate through the price. The sharp increase in demand led the price of quinoa to more than triple in just a few years. That skyrocketing price is a signal, creating a line of communication between buyers and sellers.
The price is a signal to potential suppliers.
Potential suppliers may not otherwise know much about what’s happening on the demand side of the market. Peruvian and Bolivian farmers may know little about American food trends, but they know the price of quinoa. When the price skyrockets, it sends these farmers a very clear message: “Quinoa is now more valuable—grow more quinoa!” More generally, a price tells potential suppliers how much buyers value their products, because it reveals the buyer’s marginal benefit, or willingness to pay.
The price is a signal to potential buyers.
Potential buyers may not otherwise know what is happening on the supply side of the market. Few Americans pay much attention to agricultural developments in the Andes, and so you’re probably unaware of how difficult it is for Peruvian farmers to expand quinoa production. But you do look at the prices when you’re at a restaurant or grocery store. And when the price of quinoa rises, it sends potential buyers like you a clear message: “Quinoa is scarce—buy less of it!” More generally, the price tells potential buyers about how expensive it is for sellers to produce more of a product, as it reveals the seller’s marginal cost.
These signals help coordinate better outcomes.
Price signals help coordinate the extraordinary chain of events that puts quinoa on your plate. Some of your quinoa might come from a Peruvian farmer who expands his production. And some might come from a Bolivian family that cuts back and eats more Australian-grown wheat instead. That quinoa might get to you on a Norwegian container ship that’ll transport it to the United States. All of this occurs even if you don’t know anyone in Peru, Bolivia, Australia, or Norway.
It takes an extraordinary degree of coordination to get that quinoa to you. Prices are what make this miracle of global coordination possible. Price allows for the rapid-fire transmission of signals that are equally well understood in English, Spanish, Norwegian, and Quechuan (the language spoken in the Andes).
Role Two: A Price Is an Incentive
So far I’ve described prices as providing a valuable line of communication between buyers and sellers. People respond to these signals because prices serve another role: A price is an incentive. The incentive is straightforward: A high price is an incentive for buyers to cut back a bit, just as it’s an incentive for suppliers to expand production.
A high price is an incentive for suppliers to produce more.
For suppliers, a high price is an incentive to increase production, because it creates new profit opportunities. The high price of quinoa is an incentive for farmers in the Andes to switch from growing corn to growing quinoa, which is what spurred them to quadruple their production of quinoa. This high price is an incentive for Bolivians to leave their mining jobs to return to their rural villages to farm quinoa. It’s also an incentive stimulating innovation, and scientists at a Peruvian university have developed a variety of quinoa that will grow in coastal areas. A high price is an incentive with global influence, and it has led farmers in Oregon and Colorado to experiment with growing quinoa. American geneticists are hard at work mapping the quinoa genome that will help them genetically engineer new high-yielding varieties. This extraordinary mobilization occurs because the high price is an incentive for producers to increase the quantity they supply.
A high price is an incentive for buyers to consume less.
For potential buyers, a high price raises the opportunity cost of consuming quinoa, creating an incentive to consume less. This incentive has far-reaching effects. It has led many Peruvian and Bolivian families to switch from eating quinoa to alternative grains like wheat, which are now relatively more affordable. South American farmers no longer use quinoa as chicken food. And if you’ve been in an American salad shop lately, the scoop of quinoa that you get may have gotten a little smaller. Each of these folks is conserving quinoa, because the high price is an incentive for potential buyers to decrease the quantity they demand.
A price provides an incentive for strangers to cooperate.
The end result is that the quinoa that was once reserved for a South American chicken is now being served at your local salad shop. This occurs even though South American chickens neither know you, nor particularly care about you. Rather, the South American chicken farmer is moved to consume less, allowing your local salad shop to sell you that quinoa as a salad. This all happens due to the incentives embedded in the price of quinoa.
No quinoa for you.
Role Three: A Price Aggregates Information
A price also aggregates information. Learn how to interpret what it’s saying, and you’ll make better decisions. The clearest example of this involves prediction markets, in which people trade contracts whose payoffs are linked to whether an uncertain event occurs. For instance, there are prediction markets where you can buy a share that’ll be worth $1 if a Democrat wins the next election (and nothing otherwise). They’re called prediction markets, because their price effectively communicates a prediction. For instance, if the price of that Democrat stock is $0.60, you can think of this as the market forecasting that the Democrat has (roughly) a 60 percent chance of winning.
The process of buying and selling aggregates information.
Prediction markets yield useful forecasts because prices aggregate information. For instance, someone in Wisconsin who sees a lot of yard signs and bumper stickers supporting the Democrat might buy stock, while someone in New Mexico who saw the candidate give a bad speech might sell it. Good polling numbers might lead more people to buy the stock, while rising unpopularity might lead others to sell it. And so it goes on.
Through this process, the price will come to reflect—or aggregate—all of this information. Careful studies have shown that prediction markets yield more accurate forecasts than public opinion polls, statistical models, or televised experts. This means that you can quickly become an expert on politics without ever reading Politico—simply follow political prediction markets online.
Market prices broadcast useful information.
The same idea applies in other markets, and there are many financial prices that yield valuable business intelligence. The price of financial contracts linked to Federal Reserve decisions reveals the odds that interest rates will rise. The price of futures contract—where a buyer agrees to purchase a commodity like oil, wheat, or natural gas at a specific time in the future—is effectively a bet on the future price of these commodities. Tracking the price of these contracts can provide useful intel about future disruptions to your input costs. In financial markets, traders bet on whether inflation will be high or low, and so the price of these securities (they’re called “inflation swaps”) can yield useful inflation forecasts. While some of these financial products might seem a bit obscure, the broader idea is that because prices aggregate information, they provide you with useful business intelligence.
EVERYDAY Economics
Use markets to pick a better bracket
Sports-betting markets are effectively prediction markets, because a bet on your favorite team is the same as buying a security that’ll only pay off if your team wins. The prices in these markets—the betting odds—aggregate information from thousands of bettors, who have studied just about every conceivable detail about each team. As a result, studies have shown them to be incredibly accurate. And that’s your opportunity: Use these prices as an aid while filling out your March Madness bracket, and you’ll effectively be drawing on the expertise of thousands of sports-mad bettors. My co-workers will tell you this works—I’ve won the workplace bracket a few times.
