What Price Theory Is And Is Not
Deep Dives
Explore related topics with these Wikipedia articles, rewritten for enjoyable reading:
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Armen Alchian
1 min read
The article directly paraphrases Alchian's insight about predicting behavior from understanding the rules of the game. Alchian was a foundational figure in price theory and UCLA economics, and understanding his work illuminates the intellectual tradition this article builds upon.
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Irving Fisher
13 min read
The article mentions that Hirshleifer's work builds on Irving Fisher's earlier contributions to investment theory. Fisher was one of the most influential American economists, pioneering work on capital, interest, and intertemporal choice that underlies modern price theory.
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 ...
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