Why Do Things Cost So Much? The Basics of Prices

Why do groceries cost so much? Why is the price of gas rising? Will I be able to afford important services like education and health care?

These are all questions related to the concept of prices.

In his 1776 book, The Wealth of Nations, Adam Smith offers his explanation of how "the invisible hand" sets prices in a free market. When a supply of goods brought to the market is less than people want to buy (demand), buyers will offer more money in competing to buy the product. If the supply of goods is more than people want to buy, the price will be lowered, so surplus goods can be sold to those who are only willing to pay less. When the amount supplied is exactly the same as the amount demanded, the seller should be able to charge what Smith calls the "natural price," the price that accurately reflects the cost to the seller.

This is the basic concept of supply and demand. In the free market, prices naturally gravitate toward the point where the price of the amount supplied equals the price the public is willing to pay for the amount they demand.

Prices are helpful because they communicate information and coordinate the actions of millions of independent people. When prices rise, suppliers know to produce more of a good because they will get more profit. This has been the case with oil prices. Estimates have repeatedly predicted that world oil reserves would have disappeared years ago. Yet as prices rose, so did the incentive to find more oil, and so did the estimated supply. Conversely, when prices for an item drop, it indicates that suppliers should slow output, because not as much of a product is wanted.

Other considerations enter into the price a seller sets. For example, a farmer prices apples based on how large a crop is expected. The grocer, in turn, figures the wholesale price of apples into the retail price to make a profit. The grocer may have to raise or lower prices based on how quickly or slowly customers are buying the apples. While the seller has power to set the price, the buyer is always free not to buy at that price.

Prices rise for many reasons. Bad weather can ruin a crop of food, limiting the available supply, which raises the price and indicates scarcity. Food prices may also go up because of higher fuel prices to transport the food. Fuel may cost more because of refineries closing or foreign suppliers slowing their oil output.

One of the reasons health care prices are higher in the U.S. than in other countries is the greater number of expensive tests and preemptive procedures performed. Providers also have more freedom to raise prices in a market where services can be extremely valuable and urgent.

In addition, rising prices are a sign of inflation. Inflation means that the value of the dollar is decreasing. Since each dollar is worth less, consumers have to spend more dollars to purchase the same item as before. Hence, they pay higher prices even if an item's value remains the same. For example, the CPI Inflation Calculator from the Bureau of Labor Statistics shows that the worth of a dollar bill in 1913 would have equaled more than 23 dollars in today's currency. This is a large reason current prices sound so much higher than those of a century ago.

In real terms, prices for gasoline and health care have soared in recent years. However, looking over the last decade or so, the actual cost of clothing and certain food items has dropped significantly in the U.S.

Government intervention in the market tends to distort prices. For instance, some believe that the availability of higher education subsidies like Pell Grants actually encourages colleges to raise prices in order to get in on the money. Other times, high market prices prompt government to set price caps to keep prices low. The intention is to keep the commodity affordable, but the results are often counteractive. History shows that caps bring inflation, produce shortages, and hurt the economy. Laws against price gouging, a form of capping prices during times of emergency, can potentially do more harm than good. Rather than taking advantage of disaster victims, a natural rise in prices could actually keep scarce goods available for those who need and value them most.

Economist F.A. Hayek points out in The Use of Knowledge in Society that no one has perfect understanding of how to coordinate all the resources in the world to their best use. Rather, Hayek defines "the price system as such a mechanism for communicating information." In this way, many disconnected pieces of information work together by the medium of prices to best allocate scarce material.

Milton and Rose Friedman say something similar in their book Free to Choose: "Adam Smith's flash of genius was his recognition that the prices that emerged from voluntary transactions between buyers and sellers—for short, in a free market—could coordinate the activity of millions of people, each seeking his own interest, in such a way as to make everyone better off."

Prices continue to rise and fall based on supply, demand, and government intervention. This topic offers a look at the theory of prices, the condition of prices today, and the effects of various market or government forces on the price system.

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Venezuelans spend next to nothing and consume more gasoline than their neighbors due to a longstanding fuel subsidy. Though the country loses more money on the subsidy than they spend on healthcare, they are hesitant to remove the perk citizens have come to expect.

"It is constantly reported that the price of attending college is rising. In a time when inflation has been prevalent, what does that actually mean? To put the cost of higher education in perspective, compare it to two of the other important expenses we face: medical care and housing. Between 1987 and 2008, the cost of healthcare increased by 5.0% per year on average and the cost of housing...

"The plate has always been a great fortifier. Soup to heal, stew to comfort, escape delivered in a good piece of chocolate. But events both at home and internationally are conspiring to shake the confidence of eaters. Global famine, war and disaster are no longer so easy to keep from the table."

"The retail cost of menu items for a classic Thanksgiving dinner including turkey, stuffing, cranberries, pumpkin pie and all the basic trimmings increased less than 1 percent this year, according to the American Farm Bureau Federation."

Williams gives an excellent, quick overview of the role markets and prices play in bringing order to society without the need for government control, management, or interference.

"Global food prices are moving ever higher, hitting record levels last month as a jittery market reacted to unpredictable weather and tight supplies, according to a United Nations report released Thursday."

While it might be tempting for the government to try to control the price, this article explains why letting industry freely set high prices leads to the best allocation of gas in society for both the rich and the poor.

In real terms, grocery prices are much lower than they were 150 years ago, according to one magazine. The magazine credited higher wages and a greater availability of food for the change.

"There is a simple reason health care in the United States costs more than it does anywhere else: The prices are higher."

Apple uses a different pricing strategy than other manufacturers, called price maintenance. Other manufacturers may offer wholesale discounts to retailers, who can then turn around and attract customers with a sale price that is higher than wholesale, but lower than the "manufacturer suggested retail price" (MSRP).

"Several conclusions can be drawn from all this. First, there is no absolute and objective gauge of inflation. Any particular measure is simply one way of making the calculation, based on a host of assumptions. Second, a number of the costs that middle-class households face are going up considerably faster than the CPI [Consumer Price Index]. Printer-ink cartridges may be a particularly obnoxious example, but they're not the only case where prices are rising more than official statistics indicate. At the moment, these trends aren't highly visible because the economy is so sluggish. But as the recovery continues, there's every reason to think that they will become more widespread."

"Prices go up, sometimes steadily, sometimes in leaps and bounds, and although they may occasionally slide in the other direction, higher prices are the rule. Over the past ten years, prices nationwide have gone up an average of about 2.5 percent per year, a healthy rate of inflation, says Northwestern University economics professor Giorgio Primiceri. The upward march, however, is not uniform across all the goods and services tracked by the consumer price index (CPI). In the last decade, the CPI category indexes of food, housing, transportation, medical care, and education have gone up nationwide compared with the overall inflation rate, while those of recreation, communication, and apparel have gone down."

Today, more food can be bought with the same amount of money than 30 years ago (adjusted for inflation). Food prices fluctuate from supply and demand. For example, bad weather may lower supply and therefore raise prices. An increasing population that consumes more meat per person also affects prices by increased demand.

In the name of fighting inflation, price speculation, and unaffordable for the poor, Ecuadorian president Rafael Correa is instituting price controls. However, the inevitable result of this will be a shortage of basic food and unintended consequences like cronyism and black markets.

Von Mises is important because his teachings are necessary to the preservation of material civilization.

The state of Maryland regulates hospital prices, which has kept them from rising as fast as in other parts of the country. However, the costs have been offset by extra Medicare reimbursements of about $1 billion per year. To deal with expenses that have begun to get out of hand, the state has decided to put caps on the price spent per person.

"The earth’s natural resources are finite, which means that if we use them continuously, we will eventually exhaust them. This basic observation is undeniable. But another way of looking at the issue is far more relevant to assessing people’s well-being. Our exhaustible and unreproducible natural resources, if measured in terms of their prospective contribution to human welfare, can actually...

"When oil prices hit record levels, many people look for a scapegoat, and hugely profitable oil companies are an easy target. Even so, the typical political 'solutions' overlook the crucial role that market prices play in resource allocation, both among competing uses in different areas of the world today and among competing uses in different time periods (i.e. today versus the future)....

The author addresses the economic reality of scarcity. Everything we do has an opportunity cost. To do one thing, we have to forgo another thing. This is not altogether bad, because it means we have more opportunities available. Without opportunities, there would be no costs. These costs can be reflected in prices and help society choose among resources.

The countries of Argentina, Venezuela, and Ecuador are trying to suppress inflation by artificially keeping prices low. The official inflation rate stays low, but the repressed inflation rate still rises, accompanied by a shortage of goods.

"How many people see natural disasters like the tornadoes in Tuscaloosa, Alabama, and Joplin, Missouri, and say, 'we should be working to impede the recovery and make life harder for storm victims'? Probably no one. How many people see prices rise after natural disasters like the tornadoes in Tuscaloosa, Alabama, and Joplin, Missouri, and say, 'we should prosecute "price gougers"!'? Probably a lot. And yet prosecuting price gougers makes life harder for storm victims."

That magical role of prices in directing resources is the bread and butter of economics. But to the non-economist, high prices are just a form of gouging that ought to be stopped. It's wrong to let people profit from the distress of others.

"Over the past 200 years or so, many of the world's conflicts have developed around a little-known debate in economic theory. The outcome of this argument has had an impact equal to that of a major war. As an educator, I find it one of the most important but difficult concepts to teach to students, but let me take a shot at explaining it to adults."

In response to possible congressional price controls on energy costs in California, this article recalls historical lessons from ancient Egypt to Colonial Britain that teach the folly of price controls.

"We spend less of our money on groceries than we did 30 years ago."

Using data from the Consumer Price Index, the author found that, between March 2010 and March 2011, transportation prices had seen an increase of over 9.8 percent (adjusted for inflation). Gas was up 27.5 percent and education 4 percent, while the price of clothing and technology was down.

Dr. Cravens gives a basic explanation of how prices are set based on supply and demand. The author gives an example of how the price on apples is set. Farmers and retailers decide how much to charge based on how many apples they have and how fast customers are buying them. The seller has the power to set the price, but the buyer is always free not to make the purchase. This may encourage the seller to set a lower price.

"Staying healthy in the United States is expensive. In fact, in 2009, the average annual cost of health care was $7,960 per person -- two and a half times what it was in Japan for the same year."

"Analysts say gas prices are going up for two basic reasons: oil prices are rising, and refineries are shutting down."

"WHAT prices will today's home buyers get if they sell a decade from now? Most people live in their home for many years. They don't need to view it as an investment at all, but if they do, they surely need a long forecasting horizon. The problem is that modern economics has a poor understanding of past movements in home prices. And that makes the task of predicting the state of the market in 2023 challenging, at the very least. Still, we can learn something by analyzing the factors that affect home prices in general."

"In the same way that a Ponzi scheme or chain letter initially succeeds but eventually collapses, socialism may show early signs of success. But any accomplishments quickly fade as the fundamental deficiencies of central planning emerge. It is the initial illusion of success that gives government intervention its pernicious, seductive appeal. In the long run, socialism has always proven to be a formula for tyranny and misery."

Chart or Graph

"...Food inflation hit its all-time high of 28.7% in 1917 (Figure 2)."

"It is constantly reported that the price of attending college is rising. In a time when inflation has been prevalent, what does that actually mean?"

"In the last decade, the CPI [Consumer Price Index] category indexes of food, housing, transportation, medical care, and education have gone up nationwide compared with the overall inflation rate, while those of recreation, communication, and apparel have gone down."

Chart 1.6 from each year's report shows the percent increase in both CPI inflation and in core inflation between January 2000 and November 2008.

"Global food prices are moving ever higher, hitting record levels last month as a jittery market reacted to unpredictable weather and tight supplies, according to a United Nations report released Thursday."

Real prices for meats and other food items have dropped significantly in 30 years, as seen in this chart.

"The average price for a gallon of gas has [risen] more than 10% this year. Residents in North Dakota pay the most as a percentage of their income."

"The price tag for medical care is dramatically higher in the U.S."

Setting artificially low prices on energy is costly. In 2011, Saudi Arabia spent $61 billion, or 10.6% of GDP, to subsidize energy. Venezuela, which practically gives away its gasoline, spent 8.6% of GDP to keep prices low.

Led by a 28 percent increase in gasoline prices, the prices of meet and fresh vegetables increased by double digit percentage points from March 2010 to March 2011.

This chart shows how various prices changed between March 2010 and March 2011. Gasoline and transportation by far saw the highest increase, while communication saw the greatest decrease in prices. Values are adjusted for a 2.7% rate of inflation.

Petroleum prices catapulted in the 1970s and 1980s under the influence of the Organization of Petroleum Exporting Countries (opec). After that, as Figure 1 shows, real oil prices returned to their historical levels, until 2003, when oil prices increased significantly again."

This interactive chart shows what happens when prices are too low or too high. Prices that are too low create shortages. Prices that are too high create a surplus. Prices that balance supply and demand are at equilibrium.

"The retail cost of menu items for a classic Thanksgiving dinner including turkey, stuffing, cranberries, pumpkin pie and all the basic trimmings increased less than 1 percent this year, according to the American Farm Bureau Federation."

In February 2013, 20.4 percent of items were out of stock in stores.

"In 2006, USDA estimated that the average farm-value share of all food products of U.S. farm-origin consumed in the United States (both at-home and away-from-home) was 18.5% (Figure 6) out of an estimated $880.7 billion."

Analysis Report White Paper

Dr. F.A. Harper examines the question of who should decide the rate of exchange. Should one of the two individuals involved in a trade decide the price? Then one would have coercive power over the other. Should a disinterested third-party decide the price? He would have even less information on which to base his decision.

"In Chapter VIII, which ostensibly shows how the market determines prices, the analysis attempts to demonstrate that in reality it is not so much the 'market' per se that establishes prices but rather it is the firm which sets them at all times.

Rose explores the various ways information influences decisions in economies, the optimal amount of information, and problems with asymmetric information in production and quality.

Rose gives a very thorough and important lesson on the critical role of prices by showing how information is conveyed through prices, how private ownership is essential for market forces to determine the prices.

This in-depth article lays out the fundamental argument against price controls, namely, that price controls distort the allocation of resources and lead to surpluses, shortages, black markets, and long lines.

"Counter to the 'start high, end high' effect of anchors in individual judgments and dyadic negotiations, 6 studies using a diverse set of methodologies document how and why, in the social setting of auctions, lower starting prices result in higher final prices. Three processes contribute to this effect.

"History shows that price controls lead to shortages and stagnation. So why do we want to control prescription drug prices?" In answering this question, Morton outlines the negative impacts of price controls through history up to the present, and concludes with ways that prescription drug prices could be lowered through the market.

"If public policy ought especially to protect persons during periods of emergency — and that is the claim of some advocates of price gouging laws — then price gouging laws should be repealed if it is found that they lead to more harm than good for such persons."

"My three sons, ages seven to twelve, suffer from a chronic condition I've heard described by economist John Baden as ironitis—the love of anything made of metal. They are fascinated by cars, trucks, backhoes, tractors and—well, you get the idea. The other day, my middle son suggested that my next car should be a convertible.

Video/Podcast/Media

"Is the economy at risk of another boom-bust cycle in housing? Or is there a healthier, more sustainable tint to this new housing surge?"

This interactive tool, adjusted for inflation, calculates how much money will be left over after buying groceries on a budget of $35.46. Remaining amounts after purchase are shown for 2002, 1992, and 1982. More money tends to be left over with each later decade.

"Americans spend less on groceries than they did a few decades ago. That's partly because of new machines and technology that have made it much cheaper to produce food."

Listen in as Munger and EconTalk host Russ Roberts discuss the human side of economics after a catastrophe.

"Prof. Steve Horwitz addresses the common belief that the world is running out of natural resources. Instead, there are economic reasons why we will never run out of many resources. In a free market system, prices signal scarcity. So as a resource becomes more scarce, it becomes more expensive, which incentivizes people to use less of it and develop new alternatives, or to find new reserves of...

"Is price gouging bad? Is Minimum Wage good? We'll see what government price controls do compared to the market setting the price."

Friedman breaks apart the many different natural resources and processes involved in making something so seemingly simple as a wood pencil.

"Have you ever stated economic principles as haiku? Have you tried? Economics professor Art Carden takes the challenge in this short video on the laws of supply & demand."

Prof. Matt Zwolinski shares several reasons he thinks price gouging is not immoral and should not be illegal. He says that raising the price on scarce goods during times of emergency can actually reserve those scarce resources for those who would value them the most. The higher prices also incentivize people to transport more of those resources to the region of scarcity. He reasons that laws against price gouging do not solve the underlying problem of scarcity, anyway.

The short video describes the post-World War II economy in Berlin as a result of wage and price controls imposed by the Allies. Ludwig Erhard abolished the wage and price controls, which resulted in a flourishing economy.

The Carter administration was the last to attempt to intervene directly in wage and price setting to restrain inflation. For example, the Kennedy-Johnson administrations used wage-price guideposts and the Nixon administration imposed mandatory wage-price controls.

The Associated Press examines the ripple effect of record high gas prices in a small town in Illinois.

"Why are prices important? Prof. Daniel J. Smith of Troy University describes the role that prices play in generating, gathering, and transmitting information throughout the economy. Information about the supply and demand of different goods are dispersed among different buyers and sellers in an economy. Nobody has to know all this dispersed information; individuals only need to know the relative prices. Based on the simple information contained in a price, people adjust their behavior to account for conditions in supply and demand, even if they are unaware of that information."

Primary Document

Each year, the Chairman of the Council of Economic Advisors issues the Economic Report of the President, which details the nation's economic progress using text and data appendices. It reviews last year's economic activity, makes projections, and, based on the President's economic agenda,...

This economic classic is noted for providing us with terms for and expositions of such key economic ideas as the division of labor, "invisible hand," self-interest as a beneficial force, and freedom of trade.

Kirzner delves into competition and the market process, as well as compares critiques of government regulation on competition and the market process from the "neoclassical" paradigm and the "Austrian" paradigm.

"During the 1991 to 2006 period, U.S. food prices were fairly stable—annual food price inflation, as measured by the Consumer Price Index (CPI) for all food (excluding alcoholic beverages),averaged a relatively low 2.5%. However, several economic factors emerged in late 2005 that began to gradually push market prices higher for both raw agricultural commodities and energy costs, and ultimately retail food prices. U.S. food price inflation increased at a rate of 4% in 2007 and at 5.5% in 2008—the highest since 1990 and well above the general inflation rate of 3.8%. The situation of sharply rising prices came to a sudden halt in late 2008 when the financial crisis hit U.S. markets leading to a severe economic recession. Annual food price inflation dropped to 1.8% in 2009 and 0.8% in 2010, before rising to 3.7% in 2011 driven by improving U.S. and global economic conditions. USDA projects that annual food price inflation will range from 2.5% to 3.5% in 2012 and rise to 3%-4% in 2013."

We know from years of patient refinement that competition insures the achievement of a Pareto optimum under certain hypotheses.

Henry Hazlitt's classic primer outlines a straightforward and accessible portrayal of free-market economics. An unshackled market, Hazlitt says, is the only path to "full production".

Cantillon wrote one major work which was regarded by Jevons and Hayek as an important early contribution to the theory of marginal utility.

"Price is the primary mechanism that links raw farm commodities through the various levels of the market system to the retail food product. The nature of price transmission between farm and retail levels depends, in general, on the size of the farm-value share of the retail price and the degree of market competition at each stage of the marketing chain."

This paper presents, in non-technical terms, an 'Austrian' view of how a market economy works.

Mises explained economic phenomena as the outcomes of countless conscious, purposive actions, choices, and preferences of individuals, each of whom was trying as best as he or she could ... to attain ... wants and ... avoid ... consequences.

"Hundreds of thousands of Americans of all ages continue to enjoy this simple and beautiful explanation of the miracle of the 'invisible hand' by following the production of an ordinary pencil. Read shows that none of us knows enough to plan the creative actions and decisions of others."

"Two days ago, I was favored with your polite and elegant letter of January 22d. I have received so many of your letters, within a few months, containing such important matters, in so masterly a style, that I am ashamed to confess that I have answered but one of them, and that only with a few lines. I beg you would not impute this omission to inattention, negligence, or want of regard, but to...

"The production and use of ethanol in the United States have been steadily increasing since 2001, boosted in part by long-standing production subsidies. That growth has exerted upward pressure on the price of corn and, ultimately, on the retail price of food, affecting both individual consumers and federal expenditures on nutritional support programs. It has also raised questions about the environmental consequences of replacing gasoline with ethanol."

F.A. Hayek presents a very thorough analysis on the role of knowledge and infomation in societies, how it is transmitted in various societies and economic systems, how a lack of knowledge ultimately proves to be the downfall of central planning, and other key topics.

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The reality is that most students (and people for that matter) won't speak out. It's called human nature and it was recognized in the Declaration of Independence: "...all experience hath shewn that mankind are more disposed to suffer, while evils are sufferable than to right themselves by abolishing the forms to which they are accustomed." While you might feel alone when debating a teacher,...
In the land of the free and the home of the brave, speech codes are a particularly odious example of politically correct repression on many a college campus. In some ways, college campuses are the least free places for thinking and speech in America. Your best friend for fighting your school's repressive speech codes is the Foundation for Individual Rights in Education (FIRE). Here's a short clip...
Running for office isn't easy, even in college. Not everyone is cut out for it, either. For those of you who are, this completely non-partisan section is for you. If you are inclined to pursue student government, we're not going to spend time on telling you how to get elected. A good place to go for ideas and training is CampusReform.org. Rather, we want to help you in office, as a believer in...