If, for example, consumers come to like oranges more than they had in the past, then the price of oranges will rise relative to the price of grapefruits. Farmers will soon produce more oranges and relatively fewer grapefruits. Or if supplies of iron ore fall, the price of steel will rise relative to the price of aluminum. Manufacturers will shift their production so that they use less steel and more aluminum to produce their products. If the price of gasoline rises, consumers will find ways to drive less, and they’ll also buy more fuel-efficient cars. If the wages of nurses rise relative to the wages of school teachers, more young people will study nursing and fewer will study education. If interest rates fall, businesses will increase their investments in activities such as factory expansion, worker training, and research and development.
Changes in prices relative to each other directs businesses to increase their outputs of goods and services that consumers now demand more intensely (goods and services whose prices are rising) and to decrease their outputs of things that consumers no longer want as intensely as they did in the past (goods and services whose prices are falling). Importantly, the pattern of relative prices also “tells” businesses and entrepreneurs how to produce their outputs at the lowest possible costs. For instance, if the price of natural gas falls relative to the price of electricity, some business owners who would otherwise have used electricity to heat their factories or office buildings will instead use natural gas.
If the pattern of relative prices of consumer goods and services accurately reflects differences in the intensities of consumer demands for all of the different outputs produced in the economy—with prices rising for products in higher demand and falling for products in lower demand—producers will “know” what is the best mix of outputs to produce for sale to consumers. The pattern of prices tells them. And producers will have incentives to “listen” to these prices. The reason is that producers earn higher profits by expanding production of outputs whose prices are rising. Likewise, producers avoid losses by producing fewer of those outputs whose prices are falling.
Getting all of these details of pricing right is key to economic health.
In a competitive market economy based on private-property rights, people tend to make correct decisions. Not always, of course. But by and large the economic decisions people make in markets are sensible ones. The reason is that each individual personally gains by making wise choices about how to use his resources, and personally loses by making poor choices. Our trust in the overall “correctness” of people’s economic decisions, however, requires that the prices that people use to guide their decision- making are reasonably accurate sources of information. There’s trouble if prices do not reflect realities. If consumers come to demand more oranges and fewer grapefruits, but the price of oranges doesn’t rise relative to the price of grapefruit, citrus growers won’t “know” to produce more oranges and fewer grapefruit. Too many workers and resources will be used to grow grapefruit; too few workers and resources will be used to grow oranges. These workers and resources will be malinvested —that is, these workers and resources will be invested in production processes that do not best meet the demands of consumers.
Likewise, if supplies of steel fall while supplies of aluminum rise, but the price of steel doesn’t increase relative to the price of aluminum, producers will not “know” to use less steel and more aluminum in their production plans. Shortages of steel will eventually arise, disrupting the production of goods that are made with metal.