Giving Thanks for Price Theory

This year, as all years

Much of the impetus for writing Economic Forces is our appreciation for price theory and a desire to spread that appreciation against the prevailing winds within the profession.

With this being Thanksgiving, we thought that it was only appropriate to spend this week’s Economic Forces giving thanks for some important lessons that price theory taught us. Some of these lessons stand alone and some might prove to be fodder for future newsletters, but all are worthy of sharing on this day of thanks.

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Thanks price theory for teaching us that costs are about more than money

In a world of finite resources, not everyone can have everything that they want all of the time. Every decision requires evaluating a trade-off. As a result, one always needs to think about the opportunity cost. A lot of these trade-offs and opportunity costs are easy to understand. If I want to buy a new television that has a price of $300, I face the trade-off between having a TV and having $300. Or, more accurately, I face a trade-off between the television and what I could otherwise purchase with the $300.

However, this insight goes much deeper than thinking in terms of monetary costs. Opportunity costs aren’t just monetary. Sometimes they involve time. For example, suppose that I decide to buy a house. I am choosing between two different houses. One house is within walking distance of my employer. The other requires a 20-minute, one-way commute. The house that is within walking distance has a higher monetary price, but which house is more expensive?

The answer depends on a lot of things. How much do I value my time? Do I prefer having time to unwind after work that can occur in a silent car? Would the commute require purchasing a new or more reliable car? How much additional maintenance would I have to do on my car because of this daily commute? How would the weather affect my ability to walk to work each day?

What this example illustrates is a fundamental lesson of economics. The cost of purchasing the house is not just the monetary price. Deciding between these two houses requires taking into account all relevant costs. This is true of every choice and a failure to take into account all relevant costs often results in incorrect predictions and bad policy recommendations.

Thanks price theory for teaching us to use efficiency as a tool for positive economics

This one might be a more controversial take, but here goes. In common parlance, the word “efficiency” has a variety of meanings. Sometimes people use it as a synonym for “best” and sometimes people use it to mean the least costly way of doing something. In economics, the term efficiency most often refers to Pareto efficiency. This means that all gains from trade are exhausted, or that no person can be made better off without making someone else worse off. A different way of saying this is that, in equilibrium, the marginal benefit equals the marginal cost.

A lot of economists use Pareto efficiency as a criterion for welfare analysis. They write down a model and determine the Pareto efficient allocation and then consider whether a decentralized market equilibrium produces that allocation. If so, then there is no role for policy. If not, then the economist can determine what type of policy produces the Pareto efficient allocation.

One valuable lesson from the UCLA approach to price theory is to somewhat dismiss Pareto efficiency as a welfare criterion. Instead, Pareto efficiency should be used to understand the world as it is, not as what it “should” be. The basic idea is that, in general, Pareto improvements should be hard to find. If there was some change that could be made that would make someone better off without making anyone worse off, people would tend to find a way to make that happen. Thus, if one thinks that the current allocation is inefficient, then they are probably ignoring some cost or some constraint that is important for determining the actual real world allocation.

Steven Cheung provides a nice example of this in his presidential address to the Western Economic Association. Cheung gives the example of a buffet. Customers pay a flat fee and can eat whatever quantity of food that they want. The marginal cost of an extra plate of food is zero. Thus, the buffet consumer will continue to eat until the marginal benefit of eating is zero. Of course, the marginal cost of producing that last plate of food was not zero. One might therefore conclude that the buffet is inefficient. It encourages over-eating. However, this conclusion is wrong. While the marginal cost of producing that last plate of food is positive, there is a savings to the restaurant in not having to portion the meals or wait on the customers. Evidently, the savings more than exceeds the marginal cost of producing that last plate of food.

Of course, one can take this too far. Saying that one should start with the premise of Pareto efficiency to understand observed allocations is often interpreted as saying that the world is as good as it can be. However, this is not the point of the presumption of Pareto efficiency. What this presumption implies is just that this is the best people can do given the constraints they face. Relaxing some of these constraints or particular types of innovations that reduce transaction costs could result in a Pareto improvement.

For example, consider a world without money. In such a world, the only way to trade is through barter or credit. Barter is difficult because it requires a double coincidence of wants and potentially costly negotiation. Credit is difficult because some people are not trustworthy and punishment mechanisms are not always feasible. In such a world, there is a Pareto efficient allocation given these costs and constraints. However, this does not mean that this is the best possible world. The introduction of money in this economy would expand the feasible of allocations because new trading opportunities are available when one is not faced with the costs associated with credit and barter. A new, better Pareto efficient allocation results. It is important to note that introducing money into the economy is not something that is easy. It is not as though someone woke up one morning and explained their idea of “money” to the world and that was that. Money gradually emerged and evolved.

The presumption of Pareto efficiency does not mean that the world is as good as it can be, but rather that it is often difficult to make the world a better place and that one is unlikely to find policies that produce large Pareto improvements while scribbling on a chalkboard.

On this idea (and others), we are thankful for the work of Ed Lazear, whose tragic passing this week was a huge loss to price-theoretic research and education. In his great paper, “Economic Imperialism” he argued that efficiency was one of the three major tools that economists bring to any question

The importance of efficiency is not that it is an apology for the status quo. Efficiency is a concept that, together with equilibrium, pushes economists to do a particular kind of analysis. When economists model a situation and the resulting equilibrium is inefficient, usually there are trades that could have occurred that are implicitly or explicitly ruled out. The analyst or his critics are induced to ask what the reasons are and what market or other institutions could arise to remedy the situation. Thus, the focus on efficiency when combined with equilibrium prevents the economist from being content with partial answers and half-truths. The notion that efficiency is a natural outcome motivates a larger series of questions and initiates deeper analysis. It also permits economists to make clear, unambiguous policy statements, although the assumptions that lie behind welfare economics are somewhat controversial.

Thanks price theory for teaching us that profits and losses are selection mechanisms

We live in a world of finite resources. How do we as a society make sure that resources are being allocated to their best use? This is the type of question at the center of the big picture economic debates of the 20th century.

One important feature of market-based economies is the feedback provided by the profit and loss mechanism. People often have an intuitive understanding of why profit is important for allocating resources effectively and the incentives that profit-seeking creates. However, losses are just as important when it comes to the efficient allocation of goods and services. Losses send a market signal that what is being produced is not sufficiently valued by the market. Firms experience losses and shut down, freeing up resources to be allocated to a more efficient use.

What Armen Alchian taught us is that we can treat profit and losses like an evolutionary selection mechanism. Even if one doesn’t believe that firms maximize their profit, markets will tend to select for firms that are the most profitable and push out the firms who suffer losses.

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So Happy Thanksgiving to everyone (except for the haters and losers who do not subscribe to this newsletter, tell them they need to). May it be filled with lots of good food and safe Zoom calls with friends and family.

And instead of talking politics, we hope you all can learn and teach a little price theory at this year’s Thanksgiving table.