How To Improve Price Signals

The intrinsic economic value of a good or service is ultimately a function of the value that everybody in society places on that good or service.  Value is a function of scarcity.

Market prices, however, are often a function of only the value estimated by the parties to a transaction at a moment in time (i.e., the value placed on the good or service by the buyer and seller at the time of transaction).

Price could be modeled as a Taylor expansion of terms, each term reflecting the addition of more people to the approximation of price.

Current market prices are linear approximations because market transactions are bilateral (i.e., two-body problems).

For price to more accurately reflect the intrinsic value of a good or service, higher-order terms must be included in the expansion (three-body, four-body, etc.)

Physicists and physical chemists who study non-equilibrium statistical mechanics know how to do these calculations with small molecules.  You need them to model phase transitions, i.e., dynamic changes in physical state (such as melting or evaporation).

Most of the time, markets behave as simiple harmonic oscillators (i.e., linearly), and the difference between price and value is small.  This is the business cycle.

Occasionally, however, the higher-order terms in the expansion can dominate, producing a stagnant or bubble market (i.e., an overdamped or underdamped harmonic oscillator).  Incidentally, a strongly positive higher-order term in the price expansion could be the mathematical equivalent to what Charlie Munger calls "febezzlement."  His example of febezzlement is the wealth effect caused by increased spending by money managers during the upswing of an economic cycle.  Febezzlement is short for "functional equivalent of bezzlement," bezzlement being the term coined by Galbraith to name the wealth effect caused by government increases in the money supply, which he noted were not unlike the wealth effects caused by ordinary embezzlement.  Wealth effects are a non-linear term in the price expansion.

Berkshire-Hathaway has produced critically damped harmonic oscillations by making a habit of giving negative feedback, thereby damping the upward effect of valuations to a level that stabilizes oscillation.

Libertarians need to understand better the relationship between market price and externalities.  Government should not be the only entity that forces buyers and sellers (through taxes) to take into account the long-term, low-probability effects that each transaction will have on non-parties.

Again, Berkshire-Hathaway has forged a new path by selling 20-year term puts on the market.  Selling insurance on long-term, low-probability events is one way to limit the need for taxation and public regulation.

The difficulty is always in finding people who can accurately calibrate the coefficients in the price expansion.