The Price Is Never Right

“We must look at the price system as such a mechanism for communicating information if we want to understand its real function…” F.A. Hayek, The Use of Knowledge in Society

The word “inflation” is on the tip of everyone’s tongue. Aggressive monetary and fiscal policy interventions in response to the Covid-19 pandemic and an unprecedented dislocation between supply and demand in the global economy have sent prices for many goods and services soaring. Fears of a sharp and sustained spike in the rate of inflation are growing.

There are a lot of inflation threads to pull on, but for this piece I want to talk about “talking about” prices. When we discuss prices, we often speak in terms of what the price of something should be. Perhaps not explicitly, but there is often a normative judgement lodged into the conversation. Think of the number of times you’ve heard someone say: “Gas prices are crazy right now… I can’t believe how expensive it is to go to college… it should not cost so much to buy ground beef!”

Take a step back and consider this: there is no such thing as the right price for a gallon of gas, a college degree, or a pound of hamburger meat at the grocery store. Prices are simply data points that reflect thousands – if not millions – of actions and reactions simultaneously taking place around the world. Prices unemotionally convey information that can be used to make more effective decisions without having to understand the entire chain of events that led to a hamburger patty’s arrival at the store.

The great economist F.A. Hayek pays homage to this idea in his essay The Use of Knowledge in Society. He could be talking about anything, but imagine for a moment that he is talking about the recent scarcity of semiconductor chips that has made it difficult (or more costly) to buy both new and used cars:

The marvel is that in a case like that of a scarcity of one raw material, without an order being issued, without more than perhaps a handful of people knowing the cause, tens of thousands of people whose identity could not be ascertained by months of investigation, are made to use the material or its products more sparingly; i.e., they move in the right direction. This is enough of a marvel even if, in a constantly changing world, not all will hit it off so perfectly that their profit rates will always be maintained at the same constant or “normal” level.

I have deliberately used the word “marvel” to shock the reader out of the complacency with which we often take the working of this mechanism for granted. I am convinced that if it were the result of deliberate human design, and if the people guided by the price changes understood that their decisions have significance far beyond their immediate aim, this mechanism would have been acclaimed as one of the greatest triumphs of the human mind. Its misfortune is the double one that it is not the product of human design and that the people guided by it usually do not know why they are made to do what they do.

At the start of the pandemic in 2020, car companies shuttered their manufacturing plants out of concern for the safety of their workers and in anticipation of depressed consumer demand. On Ford’s Q2 2020 earnings call, they noted that production was offline for 6 weeks and the company was laser focused on operational efficiency (i.e. cost cutting). Fast forward 6 months, and Ford’s management team noted that company results: “sharply rebounded in the second half of the year as we rebuilt our inventories to meet strong pent-up demand.”

When production was taken offline, car companies canceled orders for components like semiconductors. As demand for cars came unexpectedly roaring back in 2020, many car companies like Ford were caught off guard and have not been able to rebuild semiconductor inventories quickly enough to boost production to meet the uptick in demand. In other words, car manufacturers are dealing with a general scarcity of semiconductor chips. Among other factors, this has contributed to rising prices for both new and used vehicles as supply constraints ripple through the market.

Rising prices, however, are just the messenger – not the bad guy. Both sides of the supply-demand equation are responding to price signals by – to quote Hayek – “moving in the right direction”. Car manufacturers are eagerly trying to bring more supply to market and consumers are either shopping for used vehicles or postponing a purchase decision until supplies increase and prices moderate. While this contributes to turbulence in the market and uncertainty in people’s lives, higher prices are the cure for higher prices without anyone needing to orchestrate a coordinated solution to the problem.

To be sure, rising prices can wreak havoc in people’s lives. Those living on fixed incomes will not take much solace in knowing that “eventually” higher prices may be the cure for higher prices. The government can also press its thumb on the scale with monetary and fiscal policy to such an extent that prices no longer effectively communicate information to actors in the economy. These challenges are worthy enough for their own discussion in future posts.

In the meantime, inflation will continue to dominate the headlines in the coming months against the backdrop of supply chain issues, central bank policy, and legislative proposals in Congress. While near-term distortions may cause great pain for some people, just remember that prices – or, more importantly, their fluctuations – are doing their job as they nudge billions of people around the world to allocate scarce resources more efficiently over time. The price will never be right for any good or service, but the process of trying to get there is truly a marvel.

Peak Asset Management, LLC is an SEC registered investment adviser. This is not an offer to buy or sell securities. Past performance is not indicative of current or future performance and is not a guarantee. The information set forth herein was obtained from sources which we believe to be reliable, but we do not guarantee its accuracy.