"...the standard price-setting model says rising marginal costs compress markups, not expand them. If markups are expanding, demand is doing the work."
I've noticed this come up a few times in your newsletter, in the previous post you link to and in the more recent "Are We at War with Grocery Stores Now?" where Josh says:
"While it is true that unexpected increases in costs do lead to higher prices, they also lead to smaller margins. Demand curves slope down. Firms cannot passthrough the entire increase in costs and certainly cannot raise prices by more than the increase in costs. The supply-side story is therefore inconsistent with higher profit margins."
What you say about margins decreasing at higher prices is almost certainly true, but downward sloping demand curves are not sufficient for lower margins at higher costs. We also need the demand elasticity to increase at higher prices, i.e., Marshall's Second Law of Demand (which you have a very nice presentation of in another post, I recognize I'm not breaking new ground here).
I was trained at Chicago in price theory. I sat in on three versions: Harberger, Friedman, and Becker. In each one of these courses there was always an "intuitive" level that preceded the formal model. In fact, up to the mid-1970s most questions on the price theory qualifying exam could be answered with little or no explicit math. That did not mean they were easy or that there wasn't a theory behind the questions. It was also always geared to applications. There was not an unbridgeable gap between the professional theory and a public version of it. So price theory was useful for an informed citizenry. The ultimate question I always ask myself is: In what terms do you want to understand a phenomenon? Do you want to understand it in terms of the logic of human action? Price theory does that. Without price theory, I would never have become an economist.
I enjoyed the article and agree wholeheartedly with the thesis that price theory is the background reasoning that raises the published papers to a point of relevance (being published, however, doesn’t equate to relevant). It’s the difference between being clever and being insightful, with or without a new quantitative technique. I’ve often wondered if we aren’t all, to some level, price theorists now. And just when I think it ubiquitous, I see an economist make a statement that is easily challenged by an application of price theory and feel great relief when that economist is taken to task by their colleagues. Price theory is here, it’s ingrained, and we’ll only lose it when a better tool for making sense of the how we manage scarcity is developed.
Cowen is great and has contributed a lot to the field and has been generous too, even if the book proves a point asymmetrically. You do a great job pointing out that price theory is in the background and is still relevant. It seems to reason too or perhaps my biased view, that in the competitive field of academic research for one to stand out one has to be a freak and make things complicated or unique. Price theory is fundamental, thus probably not very unique or cutting edge to do papers or research on. I think this is another reason the research reflects a decline. Thanks for the article. Some of the insights on AI are very good about the increased need for judgement. I also read somewhere - " would you trust a calculator that is 98% right when you did not have a mechanism to identify the 2% that is wrong".......AI is valuable I am sure but seems hyped in the near term.
Great article! I, as a person that works in business, think constantly a la price theory. One the most valuable tools that I learned at college. I have econ 101 with a professor with old Chicago/price theory background, it’s been very consequential in my career
“Not so fast. There’s a big difference between mostly dead and all dead. Mostly dead is slightly alive.”
https://youtu.be/xbE8E1ez97M?si=1P5Xmgt3ox4p61a9
"...the standard price-setting model says rising marginal costs compress markups, not expand them. If markups are expanding, demand is doing the work."
I've noticed this come up a few times in your newsletter, in the previous post you link to and in the more recent "Are We at War with Grocery Stores Now?" where Josh says:
"While it is true that unexpected increases in costs do lead to higher prices, they also lead to smaller margins. Demand curves slope down. Firms cannot passthrough the entire increase in costs and certainly cannot raise prices by more than the increase in costs. The supply-side story is therefore inconsistent with higher profit margins."
What you say about margins decreasing at higher prices is almost certainly true, but downward sloping demand curves are not sufficient for lower margins at higher costs. We also need the demand elasticity to increase at higher prices, i.e., Marshall's Second Law of Demand (which you have a very nice presentation of in another post, I recognize I'm not breaking new ground here).
I was trained at Chicago in price theory. I sat in on three versions: Harberger, Friedman, and Becker. In each one of these courses there was always an "intuitive" level that preceded the formal model. In fact, up to the mid-1970s most questions on the price theory qualifying exam could be answered with little or no explicit math. That did not mean they were easy or that there wasn't a theory behind the questions. It was also always geared to applications. There was not an unbridgeable gap between the professional theory and a public version of it. So price theory was useful for an informed citizenry. The ultimate question I always ask myself is: In what terms do you want to understand a phenomenon? Do you want to understand it in terms of the logic of human action? Price theory does that. Without price theory, I would never have become an economist.
Good piece, Brian. I like Lynne’s piece too. I agree with you both.
I enjoyed the article and agree wholeheartedly with the thesis that price theory is the background reasoning that raises the published papers to a point of relevance (being published, however, doesn’t equate to relevant). It’s the difference between being clever and being insightful, with or without a new quantitative technique. I’ve often wondered if we aren’t all, to some level, price theorists now. And just when I think it ubiquitous, I see an economist make a statement that is easily challenged by an application of price theory and feel great relief when that economist is taken to task by their colleagues. Price theory is here, it’s ingrained, and we’ll only lose it when a better tool for making sense of the how we manage scarcity is developed.
Cowen is great and has contributed a lot to the field and has been generous too, even if the book proves a point asymmetrically. You do a great job pointing out that price theory is in the background and is still relevant. It seems to reason too or perhaps my biased view, that in the competitive field of academic research for one to stand out one has to be a freak and make things complicated or unique. Price theory is fundamental, thus probably not very unique or cutting edge to do papers or research on. I think this is another reason the research reflects a decline. Thanks for the article. Some of the insights on AI are very good about the increased need for judgement. I also read somewhere - " would you trust a calculator that is 98% right when you did not have a mechanism to identify the 2% that is wrong".......AI is valuable I am sure but seems hyped in the near term.
Great article! I, as a person that works in business, think constantly a la price theory. One the most valuable tools that I learned at college. I have econ 101 with a professor with old Chicago/price theory background, it’s been very consequential in my career