"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...
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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