Price Discovery

"Price discovery" is a simple term to describe an incredibly complex process. It's so complex, you can think of the entire economic existence of everyone alive right now being focused on executing this one thing.

At its core, what is a "price"? When we zoom in on a single transaction, a price is the amount of currency that exchanges hands when something is bought/sold. In the larger context of all transactions, though, a price is a measure of supply and demand for "some thing" relative to all the other "things" that one could buy.

Would you rather have a Starbucks coffee ($5) or gallon of gas ($5 in California)? Would you rather have an iPhone ($1000) or a DeLonghi Dinamica Coffee Maker and Espresso Machine ($1000)? Every purchase you make requires to choose among a near-infinite number of alternate transactions you could have made instead. If we let ourselves think about the sheer number of options for spending $100 with no filter at all, it would be so overwhelming, I doubt we'd be able to function.

The Real Supercomputer

To make things worse, things change. People might want more coffee today than yesterday. They might have already bought the latest iPhone and not need another. The cost of cocoa might go from $300 / metric ton to $1000 / metric ton. An oil refinery might get blown up in Russia. Nothing about "demand" or "productive capacity" stays the same. So prices must change.

Finding the right price for everything at all times is one of the most complex problems any society has ever managed. It only gets worse as economies get larger and more interconnected. It seems impossible to solve, and may well be in any academic sense of the word "solve", since you're never done.

The practical solution turned out to be simple: let each individual apply their intelligence to figuring out their local tradeoffs. You, I, and everyone take in all the information we can and then choose what's best for us. In doing so, we turn our whole world in to a giant supercomputer with 8 billion "cores" all working the problem in parallel.

No one knows what the actual correct price is, globally or locally, but every time we buy, we say "this price is good enough for me, right here, right now". That transaction informs the other people involved, including the seller and the other potential buyers who see the transaction--who then update their behavior based on that information. We each provide information about the "right" price to the world around us every time we buy or sell something.

Any time the price for something gets "too low" (in their judgement), sellers will refuse to sell and transactions will start to dry up. Buyers will compete to capture a bargain--pushing prices up as long as they continue to represent a "good deal".

Any time the price for something gets "too high" (in their judgement), buyers will refuse to buy and transactions will dry up. Sellers will compete for the shrinking pool of buyers, lowering their asking prices to win the sale--pushing prices back down as long as they continue to represent a "good profit".

Informed buyers and sellers thus regulate the prices just by taking advantage of extreme prices for their own profit. No one has to do anything other than pursue their own self-interest, yet the combined output of billions of self-interested nodes is a global system that produces "stuff" as efficiently as possible to meet the needs of those nodes as best as it can.

If you're a real computer nerd, you'd describe it as a neural network, since each "node" (person) is connected and communicating with the neighboring "nodes" and impacting their output.

The Hive Mind that Shapes Our World

In a very real sense, the interconnected decision making driven through prices constitutes a "hive mind", working much the same way as an ant colony or bee hive.

No one is in charge. (Just like the "queen" isn't sitting around ordering worker bees to go get pollen.) It's billions of individual agents working according to their own decision-making processes, yet collectively, we end up re-shaping the world to better meet our needs.

These signals determine if farmers are planting corn or soybeans. They determine if the farmland stays farmland or get turns into condos. Further, it determines what fraction of a generation pursues college educations or become electricians. Everything about our world and lives are shaped by the "water" of prices that we're swimming through--and this makes effective price discovery one of the most powerful agents of reducing human misery.

The Folly of Central Planning

Governments often find the output of the market-based system to be less than ideal for their purposes. Sometimes, the objections are well-founded. No one wants to live in a world where your neighbor offers the lowest cost waste removal services and then improperly stores hazardous waste on their property. But many times, the central planners are trying to bend the economy to their will--and we're all much worse off for it.

There have been countless examples of central planners--meaning well--ruining (or ending) the lives of millions of people with their policies. One of the most famous is Mao Zedong's "Great Leap Forward" where he forced millions of farmers to built blast furnaces to make iron on their farms, causing a catastrophic drop in agricultural output and mass famine.

The same misallocation of resources shows up in a modern American context too (though less dramatically). Some form of central planning is responsible for:

• The current student loan crisis (and high cost of education)
• The high cost of rent and overall housing shortage
• The spiraling costs--and worsening outcomes--of American healthcare

At its core, central planning is an incredibly arrogant proposition that a small group of "experts" can do better than the performance of millions of independent, intelligent, self-interested individuals. It's like trying to replace the computational power of a network of computers with a single overconfident high school kid. The kid might seem confident and tell good stories--but it's only because he can't imagine just how much he doesn't know.

In fact, the fundamental reason that market-based economies do so well over time vs centrally planned economies (which may shoot ahead for short periods) is because price discovery is so essential and so hard. Whenever we screw this up, the misallocation of resources hurts us on such a scale that it can decades--or centuries--for societies to recover (and the individuals impacted never will).