TCS Daily

The Price of Rationality

By Martin Krause - July 11, 2006 12:00 AM

"If it barks, it must be a dog." That is why it is important to consider the arguments offered by those attempting to explain that something barking is not a dog.

Concerned about the rise of inflation, the Argentine government has been "negotiating" with private companies in order to contain the rise in prices. Well, more than negotiating. We should probably call it "arm-twisting" or open threats; as it happened with Shell last year when it raised gas prices only to see its gas stations blockaded by government-friendly "picketers" until they went back to the old prices.

A few days ago, while announcing one such "price agreement" with the Chamber of Tourism in order to keep prices stable in this area for the remainder of the year, President Kirchner denied that his administration is implementing "price controls." This is what he had to say:

"It is a new way of production to generate this kind of response, which is very important; and it is neither freezing nor price control, but rationality. The word rationality in the management of investment, rationality in forecasting, in projection, this is what we want to achieve".

The definition is full of concepts that deserve analysis. First, we should point out the assumption that "market prices," those that are the result of voluntary exchanges, are somehow not "rational," i.e. irrational. But in what sense?

Prices are not rational or irrational, but allow transactions to take place. No doubt the seller wants to sell at the highest possible prices while the buyer wants to buy at the lowest possible ones. Both parties are acting "rationally" in that way, and if the highest price the buyer is willing to pay is higher than the lowest price the seller is willing to buy, then there is a margin for both to reach an agreement to mutual benefit.

We could interpret, though, "rationality" as linked to the information prices transmit. This is the key function of the market, and it was pointed out first by F. A. von Hayek in his now famous 1945 article "The use of knowledge in society" following "Economics and knowledge" from 1937.

Hayek said information is not concentrated in a single place or mind, or in several, but dispersed through thousands and millions of different people. One of the great advantages of the market is that it works as a communication system resuming in one single number all the information available to participants in the market. Of course, this is not "perfect" information, but perfection does not exist.

The market not only transmits information (e.g. if there is a flood in Ukraine the price of wheat immediately goes up without Argentine producers knowing more about that country than the World Cup matches they look at) but also allows the "man in the spot" to make decisions with regard to resources of which he is the one who knows best and has the right incentives to do so.

The market then allows for the coordination of the decisions of producers with those of consumers, without any of them having complete information.

Such information, of course, is not concentrated anywhere and much less in the hands of government.

The mentioned articles by Hayek actually came from what was called the "calculation debate" on socialism. In 1922, economist Ludwig von Mises wrote a book warning that socialist planning was doomed to failure since, without property rights, there would be no prices for resources and economic calculation would be impossible. He called the attention of government planners that they would not be investing resources in a "rational" way, if we call rational to do it in order to supply consumers' preferences.

Every use of that official's limited rationality is a distortion with regard to the limited rationality-guided conduct of producers and consumers. They start receiving distorted signals, and act accordingly, until consequences accumulate, pressure cookers explode, and walls fall.

Dr. Martin Krause is the Professor of Economics and Dean of ESEADE Business School in Buenos Aires, Argentina.



The Cost of Debt
I agree that in a free market uncorrupted by cartels, collusion, or lesser abuses -- or the burdens of failed policies and their costs -- then price regulations of any kind (but most particularly price controls) are indeed an irrational measure.

Argentina's inflation problems, however, are nothing new -- foreign debt pushed yearly inflation to 900% in 1983 and then again to 3000% in 1989. Sound fiscal policy requires principled debt management and living within the nation's means.

Funny how things just keep coming back around.
This describes just about all the central governments in the world. They all attempt to fix prices through:
Fixing raw material costs

And they all fail. The US is not that much better than Argentina in this respect.

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