Saturday, June 26, 2021

Prices and incentives - Cannot separate the two


"A price is a signal wrapped up in an incentive."  - Tyler Cowen and Alex Tabarrok 

Prices reveal preferences. Prices reveal incentives. This is even the case if there are distortions from government intervention. With government intervention, prices reveal the preferences and incentives of the government. 

Price changes, the adjustment of market opinions and preferences, generate actions or responses from markets. If the price of lumber rises, there will be an impact on housing from builders and potential buyers. In the short-run, consumers will try and get ahead of prices changes, but eventually they will respond to the incentives placed before them and change behavior. 

An investor should not impose his narrative on prices but look to understand what prices are revealing about mass opinion. Of course, prices are noisy in the very short-run. Those short-run prices are revealing information but only about short-run behavior. That is why prices have to be smoothed to create more meaningful signals. 

The trend-follower focuses on price and incentives and does not assume he has as what Hayek would say is the "pretense of knowledge". There is a limit to knowledge so the focus should be centered on the meaning of prices. 

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