The role of prices in increasing social welfare

The role of prices in ncreasing social welfarePrices are a constant concern for policy-makers. Treasury Ministers and central bankers seem very concerned with deflation, because, according to them, low prices do not incentivize entrepreneurial activity, which is bad for the economy. On the other side, other politicians are very concerned with possible rises of prices due to changing market structures, such as the consolidations happening in the telco sector.


Some policy-makers complain if prices do not rise, others complain if they think the prices are going to rise. This situation begs the question: which is, then, better for society, prices increasing or prices decreasing?


In Telefónica’s recently published Regulatory Economics Brief, the role of prices in markets and society is explained, together with the relationship between price evolution and social welfare.


Firstly, it is important to distinguish between prices and offers, even if in our daily dealings we tend to conflate both terms. A price is the ratio at which two commodities have been interchanged by two individuals in a concrete transaction. However, the “prices” we see in a supermarket for each of the available good are not actually prices, but offers, and will only become prices if the good is actually bought. If the “price” for an apple is set at, say, 100 Euros/kilo and consequently no one buy apples, it would be wrong to say that prices for apples are 100 Euros/kilo just because the supermarket tried to sell apples at such a price.


As shown, prices are historical record. However, they have also a fundamental role to play in the market: They are the signals by which entrepreneurs guide their decisions on investment. As such, prices are a very synthetic indicator of the relative scarcity of a good with respect to its uses.


If a price rises, this means that a concrete good is more valued by society, and conveys the signal to entrepreneurs that more resources should be deployed to the production of that good, because this is what society is currently demanding. Conversely, if a price decreases, the concrete good is losing value for society, and resources should be moved from its production to other more productive uses. This process, as explained, is not automatic, but driven by entrepreneurs using prices as signals.


In the Brief, it is shown that reductions or increases in price are actually neutral for social welfare, even if they can benefit or harm specific groups of citizens in each case. However, tampering with prices may jam the price signal system, thus hindering entrepreneurs from carrying out the transferring of resources among activities in an effective way. The entrepreneurial process will go on, but the resources will be taken to the wrong places, impoverishing the society with each investment.


You can read the full Brief here.