Prices were a feature of human society from the beginning. When archaeologists uncover the earliest pieces of writing, they usually turn out to be invoices. One notable such piece is from 5000 BC, from ancient Mesopotamia — a receipt for clothing written in cuneiform script pressed into clay.
The co-evolution of prices and civilisation is, some say, not a coincidence. One philosopher says we “stumbled upon” the system of prices “without understanding it”. That was the famous economist Friedrich Hayek. He argues it was very lucky because it allowed humans to best organise our societies and economies — that is, that prices allowed civilisation to develop.
Doesn’t he have the causation back to front? Doesn’t civilisation cause prices, not the other way round? Hayek says no:
The people who like to deride any suggestion that this may be so usually distort the argument by insinuating that it asserts that by some miracle just that sort of system has spontaneously grown up which is best suited to modern civilisation. It is the other way round: man has been able to develop that division of labor on which our civilisation is based because he happened to stumble upon a method which made it possible.
This is a big claim. But it’s one I agree with.
Hayek argues two things: that humans didn’t invent the price system on purpose, and that the blossoming of our civilisations depends on prices. That we are the beneficiaries of a happy accident. It’s entirely true that prices actually predate money. A price really just expresses the value of one thing in terms of something else. Even bartering required prices of a sort: one sheep for a pair of shoes, etc.
People bartered for all sorts of goods — from milk and bread that would only last a day, to long-lasting items like tools and raw materials. Bartering for long-lasting goods was probably a precursor to money — if it would last it could be saved and used to barter again later. But the invention of currency was like pouring petrol on the fire for the price incentive. Money, if you think about it, is just an IOU for a future barter with persons unknown. This is a huge step up.
Prices expressed in terms of money give us enormous freedom to trade with a much wider set of people. They allow us to trade more and trade better. Ultimately they allow us to stop being generalists and become specialists. The reason specialised jobs exist, like apple farmer, smiths and tailors, is that prices allow us to trade efficiently. We don’t have to grow our own apples, forge our own iron and sew our own clothes. And that makes life better. When we specialise, we can improve our work. When we trade what we make, everyone benefits from that improvement.
In part, cities grew up because the more customers you can find the more you can trade and the more you can specialise. The flipside is that living in cities gave you access to a bigger range of goods made by more specialised artisans. Prices coordinated that process. This is what Hayek was describing. The price system helped create our modern world, our civilisation.
Incentives and prices clearly have a lot in common. For a seller the system is simple: give up your item and get a monetary reward. If that monetary reward is high enough the seller will work to make the item in large quantities (or grow it, import it, etc.). They will also work to make that item cheaply.
For the buyer the incentive is just the reverse. Give up the money, get the good. So far, so obvious.
The interesting part is that the incentive can work in both directions at once — both buyer and seller are incentivised by the same price. That is because the buyer and seller put different subjective values on the good. For the seller, the good is worth less than the price and for the buyer the good is worth more than the price. These differences in how people subjectively value goods are necessary for trade. If everyone put the same subjective value on everything, nothing would ever change hands!
Prices work simultaneously as incentives on buyers and sellers. It prods both buyers and sellers in the same direction — to make a trade. If they aren’t selling enough, sellers will work to make prices lower. If they can’t buy enough, buyers will work to get more money. This double effect of prices is an especially serendipitous feature of an accidental incentive system. Not all incentives work on multiple parties at once and encourage them to cooperate.
The other reason the price incentive is so powerful is that it doesn’t require central coordination. Which is not to say that we don’t regulate some prices — nor is it to say we shouldn’t. But a price system can be relied on to spring into existence almost anywhere and to self-regulate. These features are extremely impressive and very surprising. But they don’t mean the price system is magical or above reproach. In fact, this very powerful system generates some powerful side effects.
This is an edited extract from Incentivology by Jason Murphy published by Hardie Grant Books $32.99 and is available where all good books are sold.