What Price Theory Is And Is Not

A theory of behavior, not a theory of human thoughts

Last week, Brian wrote about the distinction between setting prices and controlling prices. This is a subtle, but important point. Nonetheless, the subtlety seems to have gone over the head of some critics. Of the pushback that I saw, people claimed that Brian was confused about how decisions are actually made. However, these critics mostly wanted to have a completely different conversation. They would make claims like “well we know that businessmen do X and therefore you are wrong.” Or “if you talk to businessmen, they certainly think they control prices.”

As I have mentioned before, asking people why they do things is typically a bad way to understand human behavior. There are several reasons for this. People tend to make decisions based on their observable circumstances. The butcher will tend to blame rising costs for his price increases. But the rising cost he observes might just as easily be caused by rising demand for beef as a decline in the supply of cows. Prices serve multiple roles. Prices convey information and shape incentives. As a result, what is important to the butcher is knowing how to respond to observed “rising costs.” Furthermore, the butcher’s behavior will be disciplined by the market.

But there is also this closely-related common criticism that businessmen aren’t sitting around drawing marginal revenue and marginal cost curves in order to set their prices. To which I would respond “of course they are not!” Price theory makes no such claim. People often follow simple rules of thumb for behavior. Price theory can help one to evaluate which rules of thumb are useful and which are not. However, markets also provide feedback for good and bad rules of thumb.

Price theory is not a theory of what people are thinking when they make decisions. In fact, I would go as far as to say that it has little to do with what or how people think at all — something that gets me in trouble with behavioral economists. Price theory is not a theory of mind. Price theory is a theory of human behavior.

What Price Theory Is

Price theory is based on the following idea. The world has finite resources. Not everyone can have everything that they want all of the time. There are real world resource constraints. If I understand your constraints, then I have a general idea about what options are available to you and what tradeoffs that you face. Resource constraints necessitate tradeoffs. If I understand your objective, I can predict which of the available options you are likely to choose.

In fact, I do not need to make radical assumptions about your objectives for this framework to provide a lot of useful insights. Simply assuming that you prefer more stuff to less stuff will generate many useful predictions.

But even if I do not know your objective, even just the fact that you face a budget constraint implies that there is a negative relationship between quantity demanded and price.

What is important is that none of this analysis requires a theory of mind. I do not need to understand what is going through your mind when you make a decision. You don’t need to understand price theory to make your decision. In fact, contrary to popular belief, I don’t even need to believe that you are rational to be confident in the prediction.

I can be confident that price theory will make an accurate prediction because markets will discipline your behavior. If you try to charge a price that is way too high, you will find that few consumers want to buy your product. If you behave as though resource constraints aren’t binding, you will find yourself making a lot of difficult (and suboptimal) decisions.

To paraphrase Armen Alchian, price theory is the idea that if I know the rules of the game, I can predict your behavior.

Rules of Thumb

Price theory, as a framework for explaining behavior, allows a lot of variation in the way that people think and how they make decisions about how to behave. People learn by doing. People see how other people make decisions and copy them. People learn through trial and error. People use rules of thumb. All of these ways of making decisions rely on some type of feedback mechanism. People act. They receive feedback from their actions and adapt. None of these descriptions of behavior are inconsistent with price theory.

Jack Hirsheleifer, wrote a textbook entitled Investment, Interest, and Capital. The book provides a price theoretic approach to thinking about investment decisions. His approach builds off of the earlier work of Irving Fisher. Hirshleifer not only does not reject the idea that decision-makers rely on rules of thumb, but he explicitly assumes so:

The theory of investment concerns the principles of intertemporal choice — the allocation of resources for consumptive and productive purposes over time. The optimization involved can be examined on the level of the individual or the firm, and also on the level of the community as a whole. Practical decision-makers — businessmen and government administrators — are also interested in principles of intertemporal choice…

…the decision-maker might ask: What rule shall I use to choose among the opportunities available? Investment decision rules are formulas that purport to guide choices correctly under such circumstances. (Hirshleifer 1970, p. 46 - 47)

Hirshleifer then proceeds to use price theory to discuss and evaluate different rules of thumb and criteria for investment. By doing so, he is able to both derive useful rules of thumb as well as examine existing rules of thumb to determine what rules work and under what circumstances.

There are two basic conclusions that follow. The first is that rules of thumb often follow from price theoretic insights, regardless of whether the decision-maker understands price theory. The second is that price theory can also reveal when certain rules of thumb are sometimes useful and sometimes not. This knowledge can help decision-makers to avoid the pitfalls of such rules.

Local Versus Global Knowledge

An issue with asking people for the reasons behind the decisions that they make is that their decisions are often made with local knowledge. Since prices both convey information and provide incentives, local knowledge is often sufficient for decision-making, but lacking in explanatory power. The latter requires broader, global knowledge.

For example, suppose that there is some natural disaster in Indonesia that temporarily limits the ability of firms to mine nickel. Since Indonesia is the largest source in the world of nickel mining, this would cause the price of nickel to rise. A higher price of nickel will make stainless steel more expensive to produce. Because stainless steel is more expensive, this is likely to lead to cutbacks in the production of razor blades. Consumers will therefore see that razor blades are more expensive. They might respond by deciding to shave less often. Since they are shaving less often, they will also cut back on purchases of shaving cream. This decline in the demand for shaving cream will reduce its price.

If you were to ask what caused the price of shaving cream to decline, the correct answer based on global knowledge would be that there was a natural disaster in Indonesia. Yet, if you ask the store that sells shaving cream why they reduced the price, they are likely to tell you that they lowered the price because their inventory was too high.

Notice here that both answers are correct, given the relevant information set. Nonetheless, the shopkeeper’s answer doesn’t tell us much about why the price is falling.

This distinction is a feature of how markets and the price system work. Prices allow people to economize on the amount of information that they need in order to make decisions. Neither the producer of stainless steel nor of razor blades needs to know why the price of one of their inputs has risen. These producers simply need to know how to respond to their changing circumstances. However, it is this very economization on information that limits the explanatory power of asking people why they made decisions.

“Failures” of Price Theory

One of the primary motivations behind behavioral economics is the supposed inadequacy of standard economic models. Behavioral economists like to take standard models, see where the predictions don’t line up with observations, and attribute the difference to some quirk of human psychology.

This might be a useful exercise, but it is unclear to what extent this is a useful critique of price theory. The typical price theorist isn’t making an assumption about human psychology when writing down a model of behavior. Price theory is about how we expect people to navigate the tradeoffs associated with the constraints they face. When price theory “fails” to predict behavior, it is often not a flaw in the theory itself. Rather it is a failure on the part of the price theorist to understand the relevant constraints or the decision-maker’s objective.

Other times, it is a failure of the critics to understand what price theory says and does not say. Kevin Murphy has an excellent discussion of this point with respect to “nudges” — another idea that originates from behavioral economics.

Murphy’s point is as follows. If we visualize a demand curve and we take as given a particular price, we can find the quantity demanded at that price. We also know two things. We know that buying more or less than this quantity at this price makes the consumer worse off. We also know that a lower price would make the consumer better off and a higher price would make them worse off. As a result, we can draw an indifference curve that is tangent to a horizontal price line at the point that the line intersects the demand curve. What that basic logic tells us is that if consumers buy a little more or a little less than the optimal quantity demanded, the costs of doing so are quite small. In fact, those costs are really small in comparison to the costs of buying the same quantity at a higher price.

Murphy uses this to point out that a basic lesson of price theory is that we would expect that people shop pretty seriously and intensively when it comes to paying the lowest price. However, they might still buy a little more or a little less than what is optimal at that price because the cost of making that “mistake” is quite small. In fact, in a world of costly information, there isn’t really any reason to believe that people will make the optimal choice given the low stakes. People aren’t going to pay for information if that information doesn’t give them equivalent value.

The idea that misinformed consumers can be “nudged” to make better choices should not come as a shock to price theorists. What comes as a shock is instead the claim that such nudges are somehow inconsistent with price theory.

What Price Theory Is and Is Not

In short, price theory is a theory of human action. It is not a theory of the mind or of a person’s decision-making process. What can sometimes makes this confusing is that the individual is the basic unit of analysis. Our theory outlines a decision-making process of the individual. In reality, however, we are not assuming that this is the way that people think. Rather, what we are doing is saying “suppose that a decision-maker faces the following constraints and has the following objectives, what actions would we expect that person to take?” We are using rational frameworks to explain human behavior. We are not assuming that people are rational or literally think about the economic problem in the way that the price theorist describes.

This is a nuanced point. Nonetheless, the failure to understand this point often leads to critiques that miss the mark. “People don’t think like this.” “People follow rules of thumb.” “People aren’t rational.” These might be useful conversation starters. However, they’re attacking mistakes that price theorists are not making.