The Economics of Price and Quantity Signals

The first time I thought about the relationship between quantity and price, I was a teenager working at the same job that taught me about transaction costs in labor markets. Evidently, there was much for me to learn at this rather dull junior sales job for a shipping company.

Being paid according to a fairly rigid and transparent system (employing a standard 1.25 or 2.0 multiplier for evening shifts and Sundays/public holidays) meant that my monthly take-home pay varied by (a) how many shifts I worked and (b) how many of those shifts were subject to extra pay. 

Not having strict family commitments (or many commitments at all, for that matter) allowed me lots of flexibility to substitute for coworkers whose kids got sick, who had doctor’s appointments, or who simply wanted time off during weekends. That’s exactly how such pay segmenting is meant to work: induce more labor supply at times when most of your labor force places a relatively higher value on leisure — and allocate those high-earning shifts among those workers who are least “hurt” by working late or weekends. 

“Least hurt” meant me and some of my younger colleagues — that part of my company’s labor force that didn’t really mind if they worked on a Tuesday or a Sunday. In a simplified sense, this is how economists think about price signals in the economy; if your workers are reluctant to work a certain day, up the price, and you get more willing workers. 

Whenever you hear economists saying that the price system efficiently allocates resources, this is essentially what we’re talking about. But for some reason, economists almost never talk about quantities.

Sure, in every introductory micro class we draw demand curves with varying price elasticities and are asked to calculate either equilibrium prices or equilibrium quantities. Even establishing cost curves or utility functions in the first place requires both prices and quantities as that’s what a curve ultimately is: a bunch of hypothetical price-quantity combinations, neatly smoothed out between axes measuring such prices and quantities. We always use quantities in relation to prices, but we hardly think much of them. What matters to economists are the prices.

What I realized when I compared my monthly paychecks was that the sum amount never fluctuated that much. Of course, a month where I worked more weekend shifts resulted in a higher total pay — but not by that much (give or take 10-20 percent). The numbers of hours I could ever clock with extra pay were completely swamped by the baseline number of regular hours that I put in. Quantity of hours dominated my take-home earnings much more than the exact price at which I sold those hours. 

We can think about this in a larger setting too. Friedrich Hayek’s great essay “The Use of Knowledge in Society” elaborated on the role that prices play in sending information about supply and demand conditions across all supply chains. As consumers or specialized producers, we don’t need to know anything about what techniques or supply/demand conditions weigh on oil extraction or iPhone production. Hayek famously used world prices of tin to illustrate his point:

In a system in which the knowledge of the relevant facts is dispersed among many people, prices can act to coordinate the separate actions of different people … Assume that somewhere in the world a new opportunity for the use of some raw material, say, tin, has arisen, or that one of the sources of supply of tin has been eliminated. It does not matter for our purpose — and it is very significant that it does not matter — which of these two causes has made tin more scarce. All that the users of tin need to know is that some of the tin they used to consume is now more profitably employed elsewhere and that, in consequence, they must economize tin. There is no need for the great majority of them even to know where the more urgent need has arisen, or in favor of what other needs they ought to husband the supply. If only some of them know directly of the new demand, and switch resources over to it, and if the people who are aware of the new gap thus created in turn fill it from still other sources, the effect will rapidly spread throughout the whole economic system and influence not only all the uses of tin but also those of its substitutes and the substitutes of these substitutes. (emphasis added)

The prices that consumers face in the store and the prices of inputs faced by a producer are enough to move their behavior in line with new market conditions; prices convey information about the world, without us having access to — or even the technical skills required to understand — the detailed knowledge of such conditions. 

As economists, we thus rely on price to carry the information from where it is to where it is needed — but quantities do that too. If a customer places a very large order at normal prices, that carries information to the producer that he may need to relate to his suppliers — in the form of higher-than-usual purchases. 

In real-world examples of the restaurant business, construction, or manufacturing, ramping up production can usually be done at standard prices. In those examples, as prices remain the same, they don’t carry any extra information about the supply and demand conditions. 

Instead, the large-order information is transmitted via quantities from one agent in the supply chain to the next: on Tuesday we need five times as much fish as usual — which means the wholesaler must acquire more fish from the fisherman, who, in turn, must catch more fish. 

This is an area where management scholars and entrepreneurs could contribute to and enrich economists’ thinking. While economists draw supply curves as upward-sloping due to more intense use of machinery, disutilities of scale, and marginally less productive labor — indicating higher costs associated with higher quantities — the entrepreneur would be tempted to do the opposite. Placing larger orders usually warrants a discount, not a price hike, as fixed costs can be divided over more unit sales. 

Entrepreneurs intuitively grasp that total revenue is given by (average) price times quantity, which means that selling much more at somewhat lower prices still yields a lot more money. Unit-price margins may fall, but margins don’t pay bills, salaries, and dividends — total income does. 

We can do this analysis for the topic of tipping as well. Americans, usually outliers in most topics, take pride in their tradition of tipping: higher price, paid directly to the server, incentivizes them to deliver better service. Withholding a tip is usually rewarded with social ostracism and poor future service. Visiting well-functioning economies like Australia or Sweden where tipping is virtually unheard of, Americans are usually quite surprised at how well they are treated. There is no tipping; price signals are not used to incentivize staff behavior; yet everything works very well. 

How could such countries possibly provide good service without the role of prices to incentivize them? One answer might be strong cultures of what we might call Protestant ethics and “doing the right thing,” but an equally tempting explanation is quantity signals; good service isn’t rewarded with tips — as in America — but in repeat customers. 

Servers and hospitality workers understand that when the business they work for thrives, they thrive too; providing good service usually make customers come back for more, which is good for everybody involved. 

Last year, Peter Boettke wrote on AIER that the basics of economics involve the following: 

We live in a world of scarcity; as a result individuals face trade-offs, they want to negotiate those trade-offs as efficaciously as they can, and in order to do that they require some aids to the human mind, which within a market economy are provided by property rights (incentives), prices (knowledge), and profit and loss (feedback for learning). 

Art Carden, another superb writer, contributor, and senior fellow at AIER, began his business cycle article by observing that “the price system is a thing of beauty,” followed by Hayek’s pronouncement that it ought to count among humanity’s greatest achievements. 

Yes, both of these scholars are wholly right to turn the economist’s spotlight to what prices do in the economy. But, to paraphrase the Stanford economist and Nobel laureate Al Roth, prices don’t do all — or even most — of the “heavy lifting” involved in economic transactions. Quantities also matter. Quantities tell entrepreneurs what to produce and where. Quantities are also a way to efficiently allocate resources across production lines under fundamental scarcity. 

We know how price signals work; perhaps we should include knowledge of how quantity signals work too.

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