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What is Price Theory?
Economic Forces is (self-consciously) a newsletter about price theory. Price theory is central to how we think about economics and analyze issues. Yet, up to this point, we haven’t written a newsletter on our most commonly asked question, “What is price theory?” We did a podcast but no newsletter. People often leave comments, “Isn’t that just microeconomics?” Some say we are just the “supply and demand guys.” While we’re happy to take a nickname from the core model in economics, it’s not just supply and demand (at least how most people use those terms).
Given the growing popularity of the newsletter (and the fact that we’ve had over 150 newsletters to try to figure out what the heck we mean by price theory), we thought it might be worthwhile to spend some time answering this question explicitly instead of our usual style of showing-by-doing with a few comments that indirectly answer the question.
In this post, we will provide the definitive answer to the question, what is price theory?
Okay, maybe not that far. Instead, we’ll summarize what we mean by “price theory” and how this approach differs from textbook microeconomics. Instead of a formal definition (that won’t help much), we’ll lay out some key features that distinguish price theory as we see it from standard microeconomics.
In this post, we provide a few short sections about what we believe to be the critical characteristics of price theory as we practice it. At the end of each section, we offer links to previous posts for those readers interested in reading further (or re-visiting old posts).
An Emphasis on Exchange
A major emphasis of price theory is on exchange between buyers and sellers. Rather than starting from hypothetical supply and demand curves, we focus on how real world agents arrive at an agreeable price through a process of coordination. Prices emerge from exchange. For example, we may think about a certain quantity of a good to be traded, and then examine what price the marginal buyer is willing to pay versus what it costs the marginal seller to provide that unit. “The market” doesn’t set the price, as much as people will say that. Marginal buyers and sellers (marginal pairs), looking for exchange opportunities, set the price.
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Again, many people will say this is just supply and demand. Yes, but by starting at the exchange step—and spending lots of time there—we engrain that exchange is the fundamental concept (not some lines), which helps us avoid making certain common mistakes. For example, one common mistake outside observers make is thinking that there are gains from trade that (a) go unrealized and (b) are somehow known to the observer but not the actual market participants. “I drew the graph and see the deadweight loss!” “I can fix it!”
Instead, by focusing on exchange, we must ask why doesn't trade occur here? This orientation shifts attention to impediments like transaction costs or constraints that the economist might not have considered when they first examined the situation.
We also view exchange very generally in price theory. We are not always just thinking about standard goods. Price theorists in the UCLA tradition often like to emphasize the importance of property rights. In an exchange, property rights are what are being exchanged. If I sell you an apple, I am transferring my property right to that apple to you. That property right gives you the exclusive right to that apple and the ability to sell that apple to someone else.
While that might seem arbitrary or obvious, re-orienting one’s thinking around property rights can lead to many interesting questions and insights. Are property rights well-defined? What are the limitations on property rights? What happens if we remove property rights? What happens if property rights are limited in a particular way?
Overall, price theory differs from textbook micro in starting analysis from exchange and the pursuit of gains from trade, not from assumed market structure and price-taking behavior.
Taking Competition Seriously
Price theory also takes competition seriously, recognizing it is omnipresent rather than restricted to textbooks’ “perfect competition.” We see all exchange happening in a competitive context, not in isolation. Firms respond strategically to rivals, not just to an abstract “market price.” For example, when buying a house, the purchase price reflects competition among many buyers, not just a transaction between one buyer and seller. Or alternatively, the buyer is competing for the house against other potential buyers AND the current owner.
A lot of microeconomics textbooks tend to focus on market structure. Is this market perfectly competitive? What assumptions do we impose to have a competitive market? What outcomes are likely to emerge? One can then ask the same questions about monopoly, duopoly, oligopoly, and monopolistic competition. This emphasis on market structure, however, can actually cloud students’ thinking about how particular terms behave.
In price theory, we tend to think of two types of firms: price-taking firms (those who do not have any control over the price of their product) and firms that set their prices. Among the firms that set their prices, some might be monopolies, but many others face significant competition. In fact, price-setting firms are often monopolies in one (legal) sense but competitive in other ways. For example, the Coca-Cola Company has a monopoly on Coca-Cola. No other firm can produce it. The recipe is secret. But Coca-Cola is competitive with other firms, like Pepsi. In fact, depending on the question at hand, the company might have a lot of competitors from all soft drinks to even things like beer and juice.
While it is always necessary to draw a boundary on what is “the market,” to much focus on defining the market can cloud our understanding of pricing behavior. Price setting firms tend to face the same decisions regardless of how the economist draws the market structure. In fact, it might help to introduce market structure only after one understands price setting. The core idea to work through is about pricing. Get that first. Then we can differentiate what is true for all price setters and what questions and problems emerge due to differences in market structure.
The crucial point here is that emphasis on market structure is too rigid. Focusing on price-taking versus price-setting is one way out.
Prices, Knowledge, and Coordination
Prices themselves play a central role in coordinating economic behavior across markets and facilitating exchange. There’s exchange again. Drink!
We see prices affecting behavior and carrying important information. Prices are not just the point on a graph where supply meets demand. Prices allow people to allocate resources and use information in a decentralized way and solve the coordination problem of who gets what. Starting with the price role of information, we immediately focus on problems associated with dispersed knowledge and imperfect information. It is not a God’s eye view of the supply and demand curve where everyone knows everything.
Price theory also recognizes that markets tend towards equilibrium through various mechanisms, not just price changes, as in textbook models. When thinking about a scenario like a price ceiling, the next question is always “What happens next?” as market agents react and adjust behavior. Price theory doesn’t produce answers like “markets do not clear” — instead, the question is how they clear. How do they coordinate? If coordination mechanisms are always present (whether prices, queuing, social norms, whatever), which ones get used when prices cannot? What other margins can people adjust on? How do people respond when prices are not allowed to coordinate behavior?
A Clear Focus on Opportunity Cost
There is a possibly apocryphal story that gets told about Armen Alchian. When he stopped teaching in the price theory sequence at UCLA, the faculty member taking over asked him what he taught in his graduate price theory course. Alchian replied, “I teach the theory of demand.” The faculty member replied, “Yes, I have a few weeks on that. What else do you cover?” To which Alchian replied, “I teach the theory of demand.”
I suspect people unacquainted with price theory do not find this as amusing as we do. A price theorist finds this quip amusing precisely because when one really focuses on opportunity cost, everything seems to be understood via the theory of demand. If the opportunity cost goes up, the quantity demanded declines. Opportunity cost is much broader than just market price but includes things like time, effort, and transaction costs. If any of those rises, the quantity demanded falls. It is all just the theory of demand.
The theory of demand is informative on many questions. If one really understands opportunity cost, applications of the theory of demand can be found everywhere. This emphasis on opportunity cost is related to another important characteristic of the price theoretic approach.
Using Simpler Models to Go Further
Price theory relies on simple models, especially compared to much of modern economics research. However, the emphasis is on digging deeper into assumptions and exploring extensions of these models. Starting simple and then tweaking assumptions can generate significant new insights. If we make up a new model for every event, we will over the data. Otherwise, next time, when the world has changed, the prediction will be terrible.
Instead, the goal is to understand root causes, which will ultimately aid us in making predictions. We hope to show in these newsletters that the simple models can explain more than most students may realize with further probing and analysis.
This is not to say that less simple models are never needed. Also, sometimes we cheat when we say “simple” models because these insights are not always simple until told. Regardless, we believe there are very deep insights in basic models that might not be obvious to those new to economics or price theory. Thus, to the novice, the theory might not appear that simple.
What we really mean by simple models is that these models and frameworks are simple enough that we can explain to relative newcomers what is going on. It may not be obvious to every Econ 101 student. In fact, we hope it isn’t. Why would we need to write a newsletter then? But you don’t need a graduate sequence in the latest heterogeneous macro models to comprehend the mechanisms at play.
By being simple to understand, the models help us identify causal relationships, formulate testable hypotheses, and make predictions. Complicated models can do this as well, but it becomes hard to identify what is driving particular results.
The Big Picture
In total, by starting from exchange, emphasizing competition, taking coordination seriously, expecting equilibrium, and using simple but extendable models, price theory generates an approach to economics that differs from textbook microeconomics. We believe this perspective provides unique and valuable insights.
Let us know in the comments if you have any other thoughts or questions on what constitutes price theory!