When we economists talk about the role of prices in a market economy, one of the points we often make is that prices determine who, among the many who would like to have a particular good, are actually able to obtain it. In other words, we must decide “who gets what.”
In a world of scarcity, the wants of human beings far outnumber the quantity of goods available, so we must find a process by which those limited goods are allocated among the multitude of possible uses that people might have for them. Sometimes we talk about this as a “rationing” system, but that runs the risk of implying that there must be an overarching “rationer.” The same could be said of the terms “allocation” and “distribution.” It turns out that the best system for solving the “who gets what” problem is the price system, because, without a designer, it alone manages to link allocation and production.
We can imagine all kinds of non-price ways of allocating a stock of resources among a greater number of ends. We could use “first come, first served” and allocate the goods by willingness to queue up. We could conduct a lottery and give one unit of the good to each holder of a winning ticket. We could follow strict equality and divide the number of each good by the number of people. We could also follow “might makes right” and let people fight it out for the goods. All these are possible ways of determining how the limited supply of goods will be allocated, or rationed, among the much larger number of possible uses. And each has some advantages and disadvantages.
Admittedly, allocation by market prices has one disadvantage: those who have less income or wealth find it more difficult to obtain the good than they might under other allocation schemes.
But whatever the advantages and disadvantages of non-price allocation systems, they all have one enormous defect: the way goods are allocated might affect their production. These schemes treat goods like manna from heaven; but the production of goods is not independent of how they are allocated. In other words, we need a system for determining which demands will get satisfied that pays attention to supply!
Market prices do this. Because prices are knowledge wrapped in incentives, they signal to potential producers what sorts of goods people want and provide those producers with an incentive to interpret those signals correctly and act on them. For example, if the price of a good rises, it becomes harder for many people to obtain the good. But that piece of information is available to actual and potential producers. The higher price means it is now worthwhile to shift resources from the production of other things to the production of the good in question, and so the supply of the higher-priced good will increase.
Notice that when goods are allocated by price, changes in demand are translated into matching movements in supply. Notice also that just as an increase in demand means people are devoting more resources to acquiring those goods than substitutes, the corresponding increase in supply generated by the price increase means that producers are bidding resources away from other, less-valued uses to devote them to producing more of the good that is in greater demand.
Allocation by price connects demand and supply in a way that no other allocation system can. Despite the worries that allocating by price and “willingness to pay” is unfair to the poor, that very same process ensures that the supply of goods is constantly growing and becoming cheaper over time. That can be said of no other system. In the end, allocation by market prices is what has made possible the enormous increases in the standard of living of the poor in the West and, increasingly, other parts of the world.
Rather than talking in terms of allocation, rationing, and distribution, all of which seem to take supply for granted, we would be better off talking about how prices allow individual choosers to more effectively economize. The system itself doesn’t economize, but it allows individuals to signal one another about how important various wants are and how effective various means are at satisfying them.
Market prices don’t just determine who gets what. They make sure that there’s always more “what” to be got.