One of the most fundamental aspects of an economy is its allocation of resources, simply meaning how and where resources such as steel, rubber, or even human labor are used. The mechanism by which this happens has tremendous effects on the wealth and standard of living of economies. In a capitalist economy, resources are allocated within the structure of the price system. While this concept is often taken for granted by average citizens—and even by many economists—it is of utmost importance to the understanding of the economy.

Friedrich Hayek’s article “The Use of Knowledge in Society” and Ludwig von Mises’s treatise Human Action (pages 324-396) both give an extensive examination of the importance of prices. They argue that economic efficiency, or the use of resources in the most valued and desired way for society, only happens through the price system.

Prices Are a Form of Communication

Without a price system, for example in a socialist, government-controlled economy, the complex issues regarding production would be impossible to resolve. What materials should be used to make a product, how much of each material should be used, how much of a product should be produced, where should these products be manufactured, and where should they be distributed for consumption? All of these questions without a price system would be arbitrarily answered.

Relatively higher prices tell people that the product is scarce and should be used in the most effective and most highly-valued way possible.

With the price system, however, prices reflect the practical conditions that people live in and coordinates activity. Relatively higher prices tell people that the product is scarce and should be used in the most effective and most highly-valued way possible. People do not need to know what caused the price to rise, they just see the higher price and tend to consume it in a responsible and conservative manner. From the point of view of the producers, they examine the options available and use the cheapest method that will get the best production.

Relatively lower prices, on the other hand, signal a decrease in the need for as much conservation—either by others not demanding it as much or there being an increase in supply—thereby freeing up the resource to be used for the next most-valuable use. This allows consumers to enjoy more of the products they want, thereby increasing the standard of living, and it grants producers easier access to more materials for the development of a larger quantity or a better quality of products or the experimentation of new products.

The effectiveness of the information portrayed by prices can be illustrated in an example. Whenever a producer is building a house, he will observe the low cost of straw, the moderate cost of bricks, and the extremely high cost of platinum. Obviously, platinum is more scarce and should be employed in only the most valuable uses. While straw is the cheapest, it will likely not make a good profit because consumers will not demand such a house, and so brick is used because it is within the bounds of budget and will yield the best profit by best serving the consumers.

This simple example of deciding on the materials to build a house may seem obvious given the choices. However, in reality, there are more complicated circumstances that are not so obvious, such as the decision to use wood, steel, or concrete. In addition, this example only looks at one aspect of the decisions that need to be made and ignores how big the house should be, where it should be built, and the quantities of the various resources and labor.

Hayek also emphasized that this system of prices is not an organized institution or structure that was created by any single person’s design. It was simply a natural consequence of trade between people even before money in a barter economy. Later the use of money, which Austrians also argue arises naturally without a government, only simplified the transactions and prices by the establishment of a medium of exchange.

The Entrepreneur and Profits

Entrepreneurial profits also play a role in the allocation of resources. Entrepreneurs are the owners of the means of production, yet they do not just arbitrarily decide what they are going to produce—they decide that based on prospective profits that they discover through economic calculation. This is where prices are particularly important in the allocation of resources.

In the selfish desires of entrepreneurs to gain profits, they compete in forecasting the future demand of consumers. If an individual believes that consumers are starting to increase their demand for bracelets, which will cause the price of bracelets to rise if there is no supply increase, he may start a project to supply that demand. This is, in effect, the entrepreneur having a foresight into future price discrepancies and acting to make profit off of it. If an individual is making a profit, that signifies that he correctly anticipated what others in society wanted and supplied it for them.

In doing business, entrepreneurs consider all the input costs whenever deciding on how to produce something.

Similarly, prices are necessary for the entrepreneur to determine whether he is correctly providing for society or not. In doing business, entrepreneurs consider all the input costs whenever deciding on how to produce something. The entrepreneur, in his desire for more profit, constantly seeks to lower his input costs while improving his product. If he is still not making any profit or is consistently taking a loss, that signifies that he was wrong in his determination of future demand and that consumers have other preferences instead.

This shows that the factors of production that the entrepreneur is using could be better spent in a line of production that is more desired by consumers. It could also mean that the entrepreneur is not efficient enough in his production, in which case it still stands that he is using resources beyond what is necessary, and the production of his product will then be supplied by another more efficient firm that takes his place and makes a profit. However, none of this could be known without considering the prices of inputs and the outcome of profit or loss, or what Mises called economic calculation.

Profits are not an unnecessary or evil aspect of the economy as many Marxians or others on the left would suggest. It is a coordinating function that signals to entrepreneurs what society wants and allows him to supply it. Without prices, there would be no way to determine the best arrangement of resources out of the infinite variety of possible arrangements. Loss of investments tells producers to stop producing, and high profits tell them to produce more until the supply is then raised to sufficiently meet demand.

Government Manipulation of Prices

Whenever natural prices are artificially changed, these prices no longer act as the signal of proper information. This distortion of the price system alters the allocation of resources and leads to scarce resources being used in irresponsible ways. These artificial prices arise out of government policies such as price floors, ceilings, subsidies, discriminatory taxes such as deductions and sin tax, and monetary interventions such as inflation.

Besides the common understanding that these manipulations can create shortages or surpluses, artificial prices cause an inherent disruption in the allocation of resources. Artificial prices reduce the efficiency of society by allowing first buyers to use the product in a less-valued way. While production is still ongoing and the economy is continuing to progress, the potential wealth of the economy is no longer being realized because the more urgent needs of consumers are not conveyed through natural prices.

The natural price system and its efficiency in allocating resources are important to learn in order to understand the free market and what it offers. Government intervention into the market, on the other hand, causes inefficiency and waste and diminishes the potential wealth of society.