Price, Value, Market Economy and Regulations

By definition, Price of a product is the money paid for it in an arm’s length transaction, whereas, Value of an asset is the intrinsic cash generation power of that asset or the value of intrinsic utility it provides to the one consuming it.

Theoretically, Price should be same as the Value and it is Prices that determine allocation of resources in an Economy. Objective is to utilize limited available resources in such a combination so as to produce maximum Value in total.

For example, if cars are priced higher than corn, it is but prudent that resources that can produce cars should be allocated there, and not misallocated to produce corn. So, in a country, based on its available resources and Prices of different products it produces, we can get a particular combination of resource allocation that maximizes its GDP.

Now, if Prices are distinctly away from intrinsic Values of their respective products, resources in the society will be misallocated and society will not be able to achieve its full Value Creation Potential. So, it is important to understand that there is a huge implication if Prices and Values are out of sync.

There are 2 systems that economies pursue for determining product Prices.

1. Command System
2. Market System.

In a Command System, Prices are determined by the State. It is assumed that Prices determined by them are accurate and close to their respective intrinsic values. But historically, as in case of former USSR and Eastern European countries, this system did not work and their economies collapsed.

In a Market System, Prices are left to be determined in the market, based on Demand and Supply principles. Theoretically, this looks like an ideal system, where Equilibrium Prices could be close to their intrinsic Values and could also keep current with any changes in conditions. But recent financial crisis has exposed two major vulnerabilities of this system.

1. Information Gap: One big assumption of Demand Supply Principle to determine Prices is that both parties in a transaction have the same level of information. If this assumption does not hold then Prices will be distinctly away from their respective intrinsic Values. For example, if selling party has more information than the buying party, Prices will be higher than what they should be. And if this information gap remains for a critical period, it may result in formation of Bubbles.

2. Price Volatility: Since Prices are determined by market Demand and Supply, they are bound to fluctuate in keeping up with ever changing conditions. This results in additional costs to businesses in form of Hedging Costs and an added Cost of Production in the economy.

This is where in a Market Economy; State must play a role by putting in Regulations. Regulations must ensure that no Information Gap exists and irrespective of complexities of financial instruments used, information should be available to all transacting parties in complete and full.