BB&T Academic Programs
What Capitalism Is
The Nature of Government
Economics of Capitalism
In a capitalist system, a price is an exchange ratio that individuals freely place on any transaction. When any two men trade in an advanced economy, they set the terms of trade as the price of exchange. Prices exist in every economy, but only under capitalism, where individuals are free to set prices (both at which they will sell and buy economic values), does the price system achieve its fullest function.
Under capitalism, prices are crucial integrators and conveyors of information. In a fully free market system, prices act to allocate resources by indicating where they will be most effectively and efficiently used. Prices perform this function by bringing together information about the value of goods and services being produced and the exchange ratios that these goods and services have relative to each other. By amassing literally millions of points of information, a price is the distillation of this information into a convenient and graspable form.
Prices reflect the balance between the supply and demand for resources (including raw materials, labor, information, and any other economic value). The law of supply and demand states, simply, that the producers of any good or service will increase their production if the price rises and that the demand for any good or service will increase as the price falls, with the inverse holding as well. What this means for an economy is that prices convey signals to producers about the quantity of goods that they should produce. The production of goods represents an implicit demand for goods and services. In an advanced economy, when primitive production for immediate use has largely disappeared, production of one product constitutes a demand for other products by exchange.
The pricing system acts to integrate the activities of all the individuals in the marketplace, signaling the producers of goods about where the most efficient use of resources is. In our example, the new production of wheat by our dairy farmer creates a larger supply to the market. For the price of wheat before his entry into the marketplace, buyers of wheat had demanded a certain quantity. Now that the quantity of wheat has increased, some suppliers will be left with surpluses at the current price level. To get rid of these surpluses, the sellers respond by lowering their price on current stocks of wheat until it is sold. The new price signals that wheat is not as valuable relative to other production as it had been before. Now, producers of wheat may choose to dedicate some portion of their output to corn, which, relative to the same resources it would require in production as those used to produce wheat, is being sold for a higher price. As a dynamic market moves forward, these price signals act to bring equilibrium to the marketplace by allocating resources where individuals can use them most efficiently and effectively.
The nature of the price system exists across the entire range of goods and services in a capitalist economy. The free functioning of the price system enables a capitalist system to allocate resources not only most efficiently but also consistent with individual freedom and justice. Individually, all members of society make decisions about the competing uses of their time, energy, and resources based on the prices of the marketplace. The price system does not, of course, protect individual producers against making incorrect decisions. They may produce a good or service that is not as valued on the marketplace as they thought (for literally hundreds of reasons, from a shifting supply to the introduction of better substitute goods to the mere changing taste of buyers). Nevertheless, even when individual producers must sell below cost, this information relays a crucial piece of information not only to that producer (stop using resources in this way), but also to every other producer in the marketplace (resources will be better used elsewhere). Even a single individual's consumption of caviar sends important signals through the price system. At the current price, he is willing to buy caviar in a certain quantity but not if the price is any higher. That information indicates to producers and potential producers of caviar how to use their time and resources in productive activity. Overall, the information that is captured by prices facilitates the interaction of specialized producers in a division of labor economy and makes productivity possible. Further, it is only under a system of capitalism, where individuals' rights to property and contract are protected and enforced, that prices reflect each individual's free choices. In other system of prices (whether they are set by a central price office or are artificially set at maximum or minimum levels), the individual is forced to use his life, time, and resources in a manner inconsistent with his judgment.