Our forthcoming Cato book, The War on Prices, provides readers with the theory and evidence to avoid popular misconceptions about inflation and price controls. It is an introduction to how economists, broadly, think about the price level (a macroeconomic topic) and the role of market prices in coordinating economic activity (a microeconomic topic).
Yet the truth is that economists themselves have been doing less “price theory” – that is, less study of how market economies address what is produced, how it is produced, and who gets what through analyzing responses to market prices. Instead, the economics academy has shifted towards doing a lot of deeply theoretical microeconomic work, as well as a host of theory-light empirical work.
In a recent paper, economists Bryan Cutsinger and Alex Salter lament this relegation of price theory and call for its revival at our universities. In doing so, their paper offers a great exposition of the importance of market prices, how price theory differs from standard microeconomics, and practical reasons why its status should be higher within economics.
First, on why market prices matter:
Price theory entails careful reasoning about the tradeoffs households and firms confront as they attempt to navigate output and factor markets. Market theory correctly places a significant explanatory weight on relative prices. Exchange ratios are not merely numbers indicating a measure of “expensiveness.” In a market economy predominantly characterized by private property rights and a legal system conducive to the exchange of those rights, prices reflect opportunity cost—the value of foregone satisfaction. These values are, of course, subjective. They exist in the minds of individual decision-makers and nowhere else. But this makes understanding the price system more important, not less. Relative prices facilitate the objectification of the subjective. By forcing market participants to confront a common set of exchange ratios, prices provide buyers and sellers a way to negotiate and adjudicate otherwise-incommensurate values. The give-and-take of the market process could not occur without prices bridging the gap from personal value-scales to interpersonal tradeoffs.
Part tatonnement-process, part mass communications network, the price system is a subtle and magnificent apparatus worthy of serious scientific attention.
They later go on to explain how this happens in more detail:
economic systems must perform four tasks:
1. Determine which goods to produce and in what quantities
2. Determine which inputs and processes producers will use to do so
3. Determine the distribution of goods among society's members
4. Determine the share of those goods allocated toward producing future goods
In a market economy, the price system performs these tasks by transmitting information about supply and demand conditions to market participants and providing incentives to use this information in a manner consistent with the behavior of others.
Market prices reflect people's willingness to pay for goods. From the producer's perspective, market prices for goods guide production by communicating which goods consumers value the most, while market prices for inputs, such as labor and capital, do so by communicating their value in alternative uses. Input owners, including workers, sell their services to employers in exchange for a claim on the economy's total output, which, along with the distribution of resource ownership, determines the distribution of income. Finally, market prices, in this case, interest rates, determine the share of current output set aside for future production. While the pattern of production, income distribution, and rate of economic growth that emerge in a market economy is the product of human action, it is not the product of human design. Instead, these phenomena emerge spontaneously.
Amen. Price theory – that is using reasoning and analysis about how economic agents respond to price changes arising from exchange – is thus, or should be, inherently central to economics. And yet, price theory is becoming less common within the subject.
Fewer economists are being taught how to think through a supply and demand framework that reasonably approximates most markets. Instead, a lot of modern microeconomics is obsessed with modelling theoretical “market failures” or deriving mathematical proofs.
That’s a shame, because price theory has inherently practical applications – it can help us think through real-world problems. To highlight this, Cutsinger and Slater compare a question from Gary Becker’s old price theory textbook to a standard, modern microeconomics text:
In Becker’s book, the driving force behind the exercises is the development of the reader’s economic reasoning and its relevance for understanding the real world. For example, in the chapter on indifference curves, Becker (p. 35) asks the reader to answer the following question:
Will a decline in the relative price of black market or stolen merchandise increase the quantity demanded of such merchandise? Is this because people become less “honest” when the price of “crime” is lower? How would you measure, at the margin, a person’s preference for legal over illegal merchandise?
Compare that type of problem with the following one found at the end of the chapter on preference and choice in Mas-Colell et al. (p. 15) that asks the reader to:
Show that if 𝑓:ℜ→ℜ is a strictly increasing function and 𝑢: 𝑋→ℜ is a utility function representing preference relation ⪰, then the function 𝑣: 𝑋→ℜ defined by 𝑣(𝑥)=𝑓(𝑢(𝑥)) is also a utility function representing preference relation ⪰.
To be clear, mathematical proofs are important. But in terms of illuminating the world, it should be obvious which question has the broader application.
The other trend in economics, of course, is to “let the data speak for itself.” Yet empirical analysis, without price theory, can lead one astray. Cutsinger and Salter highlight this using Robert Minton and Casey Mulligan’s example of the wages of barbers and farmers - which have both increased by approximately the same amount over the past century, despite a productivity boon in farming and stagnation in cutting hair.
Looking at trends in wages and productivity, a simplistic “difference-in-differences” analysis – which compares the impacts of productivity growth on farmers (the treatment group) and barbers (the control group) - would imply that productivity growth has no effect on wages.
Price theory, however, would imply a different conclusion. Increased productivity in farming would be expected to raise real farming wages relative to barbers, leading people to leave barbers’ shops to take up farming. This would continue until the supply of barbers had fallen to raise barbers’ wages to restore balance between the two markets. In fact, the only reason people would continue to be barbers at all is if the productivity gains from farming had this effect!
As Minton and Mulligan explain:
To put it another way, the DiD [difference-in-differences] “correctly” shows that occupation-specific productivity growth has little occupation-specific effect on real wages, but without clearly indicating the much larger wage effects of occupation-average productivity growth.
Without understanding price theory, then, one cannot truly understand what you are measuring and what it means.
The rest of Cutsinger and Salter’s paper thus makes the case for a bigger role for price theory in graduate economic education and economic research. It is an appeal to economists to restore price theory to its central place in economics.
But I think we need more of an appreciation of price theory among the public and politicians too. Hopefully, books like The War on Prices can pique your interest to begin a deeper dive into this form of analysis.
Remember, you can pre-order The War on Prices here.
Other links to recent work of mine
Why the UK’s fiscal rule is a joke (The Times - paywall)
A Case for U.S. Federal Deficit Reduction (and in podcast form)
Cato Economics now has a Substack, which will host some of my content.