Price theory
Price theory is a field of economics that uses the supply and demand framework to explain and predict human behavior.[1] It is associated with the Chicago School of Economics. Price theory studies competitive equilibrium in markets to yield testable hypotheses that can be rejected.
Price theory is not the same as microeconomics. Strategic behavior, such as the interactions among sellers in a market where they are few, is a significant part of microeconomics but is not emphasized in price theory. Price theorists focus on competition believing it to be a reasonable description of most markets that leaves room to study additional aspects of tastes and technology. As a result, price theory tends to use less game theory than microeconomics does. [2]
Price theory focuses on how agents respond to prices, but its framework can be applied to a wide variety of socioeconomic issues that might not seem to involve prices at first glance. Price theorists have influenced several other fields including developing public choice theory and law and economics. Price theory has been applied to issues previously thought of as outside the purview of economics such as criminal justice, marriage, and addiction.
History
Alfred Marshall’s neoclassical approach combined classical and marginalist models to create a coherent system. Marshall introduced concepts such as elasticity and clearly defined different types of surpluses.[3] Marshall used different static models to represent economic states across various time horizons. He focused on studying equilibrium through ceteris paribus analysis and measured actors’ responses to incentives based on elasticities as opposed to deriving results from abstract principles. His system would lay the framework for nearly all future price theory.[4]
Although the Chicago School would become best known during the 1950s and onwards, Chicago economists were already employing and defining price theory before World War II. Chicago’s core graduate price theory course, Econ 301, set the program’s approach apart from more conventional “microeconomics” classes offered at other schools. Chicago’s unique tradition of price theory began with Jacob Viner and Frank H. Knight in the 1920s.[5] Viner contributed to price theory by modeling the firm and developing the long- and short-run cost curves that are still used and taught in economics courses today.[6] Viner and Knight were responsible for Chicago’s price theory course throughout the 1920s and 1930s and taught successful economists including Milton Friedman, George Stigler, and Paul Samuelson among others who would further price theory’s development.
MIT’s Paul Samuelson continued to formalize price theory. While some economists like Kenneth Arrow tried to eliminate approximation, Samuelson embraced Marshall’s tradition of distilling complex data into useful aggregate descriptions. He focused on making the calculation of aggregations like the consumer price index more rigorous.[7] Among many other contributions, Samuelson expanded on Marshall by contributing to the analysis of comparative statics.[8] Although Samuelson was a leading opponent of the Chicago School, his methods saw extensive use.
In the 20th century price theory became associated with the University of Chicago’s economics department. Knight and Viner taught Milton Friedman the tenets of price theory that would become central to his microeconomic approach. Friedman’s price theory teaching drew from Marshall. He used many quantitative examples and emphasized measurement and graphical representation as opposed to abstract math.[9][10] Friedman’s perspective was also influenced by Irving Fisher’s theory of interest and his contributions to general equilibrium theory. Fisher was a pioneer of econometrics and helped develop the concept of index numbers in the tradition of Marshall.[11] Friedman also built on the fundamentals of price theory by redefining Marshallian demand, a contribution important to much of price theory.
Chicago’s George Stigler expanded price theory’s scope to study imperfect information and oligopoly. He also continued teaching in Chicago’s tradition of price theory. As the economics profession became more interested in information asymmetries Stigler (1961) showed that the theory of competitive price is still a powerful approximation even in markets with imperfect information.[12] In his most famous work Stigler employed a price theoretic approach to measure the susceptibility of an industry to collude. His work would influence antitrust regulation and future price theoretic studies of mergers.[13]
Chicago’s Arnold Harberger combined Stigler’s work on imperfect competition with general equilibrium theory and tighter empirical analysis. In doing so, he was able to extend price theory to study the dead-weight loss resulting from market power in the United States economy.[14] Harberger continued Chicago’s tradition of teaching price theory training dozens of Ph.D. students including Nobel Laureates Robert Lucas and Merton Miller. Harberger used price theory to guide his policy advice. His students went on to become central bank presidents in Argentina, Chile and Costa Rica. His ideas about the causes and consequences of inflation influenced Latin American economic policy and emphasized the policy-focused approach that epitomized the Chicago School during the 1950s, 1960s, and 1970s.[15]
Perhaps the greatest effort to expand price theory’s scope came from Gary Becker who took on a greater variety of important questions than any other contemporary economist. In addition to maintaining Chicago’s tradition of teaching price theory, Becker also built on the foundations of price theory by demonstrating among other results that the law of demand does not require optimizing behavior.[16] Becker synthesized the work of his predecessors and applied price theory to fields traditionally viewed as outside the purview of economics. In his PhD dissertation he derived the demand for discrimination by biased customers and the cost to firms of being more biased than their customers. Becker also used a price theoretic approach to study criminal justice, intellectual property, marriage, lobbying, and the family influencing not just economics but also sociology and demography. In his most famous work, Becker developed the concept of human capital. Becker’s work was disproportionally responsible for price theory’s prominence in the economics profession in the latter half of the 20th century.[17][18]
Becker’s contemporary, Sherwin Rosen made fundamental research contributions to several fields. His most prominent result was his work on hedonic prices.[19] Rosen explored the properties of the hedonic pricing function and explained how dynamics over time in supply and demand affect it. This modernization of Adam Smith’s Theory of Equalizing Differences helped advance several economics subfields, such as the value of a statistical life where Rosen was a pioneer. In addition to his work on hedonics, Rosen made key contributions to the economics of superstars, the economics of tournaments, and his work on human capital investment. In joint research with Professor Robert Willis he established the central role that comparative advantage plays in determining the returns to education.[20] Along with Becker, Rosen trained dozens of Chicago Ph.D students including Kevin M. Murphy.
Becker’s later partnership with Kevin M. Murphy led to more advances in price theory. They used it to revisit and advance the topic of complementary goods, using it to examine addictions, advertising, and social interactions.[21][22][23]
In the second half of the 20th century, much of the economics profession shifted away from price theory towards alternate approaches such as game theory, behavioral economics, and information economics. Chicago, which saw itself as distinctive from the rest of the economics profession, maintained its strong tradition of price theory and continues to teach its unique approach to this day.[24]
Applied Examples
Discrimination
Gary Becker was the first to apply price theory’s framework of utility-maximizing agents interacting in a market and reaching an equilibrium to racial discrimination. Becker observed that discrimination has consequences both for people being discriminated against and for those engaging in discrimination. If a firm refuses to hire black workers, it will have to pay more to employ only white workers. In this scenario, black workers are paid less, and the discriminating employer pays more for the same level of output.[25]
Becker predicted that in the long run black workers would relocate to work in places with less discrimination. This would reduce the effect of discrimination. Becker’s work also suggested that non-discriminating employers would have an incentive to hire black workers if they were being paid lower wages, eventually driving their wages up. According to Becker, if enough non-discriminating employers entered the market the wage differential between races could be eliminated entirely. Becker’s work suggests that competition can act to reduce discrimination in the labor market. Discrimination could persist in a competitive market, however, if customers preferred businesses that did not hire black workers and were willing to pay a higher price in equilibrium to subsidize discrimination. [26]
Safer Cars and Automobile Accidents
Price theory often studies the unintended consequences of regulation. Sam Peltzman found that the installation of mandatory safety mechanisms in automobiles did not decrease highway deaths in 1975. Peltzman argued that safety technology had saved some drivers’ lives at the expense of more pedestrian deaths and nonfatal accidents as safer cars incentivized reckless driving. These second-order effects were ignored by technological studies of the time that only focused on the drivers’ lives.[27]
Unintended Consequences of Government Stimulus
In 2008 the United States was mired in the Great Recession and Congress passed the American Recovery and Reinvestment Act of 2009.[28] Keynesian economists called for aggregate demand stimulus. In evaluating the intended and unintended consequences of this policy, Casey B. Mulligan used the price theory framework to document several substitution effects that he argued reduced peoples’ and firms’ incentives to work, save, and invest.[29][30]
Notable people
Armen Alchian Arnold Harberger
Casey B. Mulligan Edward Glaeser
Michael Grossman Michael Kremer
Milton Friedman Richard Posner
Robert A. Pollak Robert Willis
Theodore Schultz Tomas J. Philipson
References
[1] Jaffe, S., Minton, R., Mulligan, C.B., & Murphy, K.M. (2019). Chicago Price Theory. Princeton University Press. p 1.
[2] Jaffe, S., Minton, R., Mulligan, C.B., & Murphy, K.M. (2019). Chicago Price Theory. Princeton University Press. p 3.
[3] Alfred Marshall | British economist. (2020, July 22). Encyclopedia Britannica. https://www.britannica.com/biography/Alfred-Marshall
[4] Weyl, E. Glen (2019). Price Theory. Journal of Economic Literature, 57(2), 345. https://doi.org/10.1257/jel.20171321.
[5] Viner, Jacob (2017). Lectures in Economics 301. Routledge, 1.
[6] Viner, Jacob (2017). Lectures in Economics 301. Routledge, 4.
[7] Weyl, E. Glen (2019). Price Theory. Journal of Economic Literature, 57(2), 345. https://doi.org/10.1257/jel.20171321
[8] Weyl, E. Glen (2019). Price Theory. Journal of Economic Literature, 57(2), 346. https://doi.org/10.1257/jel.20171321
[9] Weyl, E. Glen (2019). Price Theory. Journal of Economic Literature, 57(2), 347. https://doi.org/10.1257/jel.20171321
[10] Friedman, Milton. (2017). Price Theory. Taylor & Francis Ltd.
[11] Fisher, Irving (1923). The Making of Index-Numbers: a Study of their Varieties, Tests, and Reliability, 33(129), 90-93. https://doi.org/10.2307/2222922
[12] Weyl, E. Glen (2019). Price Theory. Journal of Economic Literature, 57(2), 348. https://doi.org/10.1257/jel.20171321
[13] Weyl, E. Glen (2019). Price Theory. Journal of Economic Literature, 57(2), 349. https://doi.org/10.1257/jel.20171321
[14] Weyl, E. Glen (2019). Price Theory. Journal of Economic Literature, 57(2), 349. https://doi.org/10.1257/jel.20171321
[15] Levy, D. (1999, March 1). Interview with Arnold Harberger. Retrieved September 23, 2020, from https://www.minneapolisfed.org/article/1999/interview-with-arnold-harberger.
[16] Becker, Gary. (2017). Economic Theory. Taylor & Francis Ltd.
[17] Weyl, E. Glen (2019). Price Theory. Journal of Economic Literature, 57(2), 351. https://doi.org/10.1257/jel.20171321.
[18] Landsburg, Steven E. Price Theory and Applications. Cengage Learning.
[19] Rosen, Sherwin. (1974). Hedonic Prices and Implicit Markets: Product Differentiation in Pure Competition. Journal of Political Economy, 82(1), 34-55. https://www.jstor.org/stable/1830899.
[20] Willis, Robert J. and Rosen, Sherwin. (1979). Education and Self-Selection. Journal of Political Economy, 87(5). S7-S36. https://doi.org/10.3386/w0249.
[21] Becker, Gary S. and Kevin M. Murphy (1988). A Theory of Rational Addiction. Journal of Political Economy, 96(4), 675-700. https://www.jstor.org/stable/1830469.
[22] Becker, Gary S. and Kevin M. Murphy (1993). A Simple Theory Of Advertising As A Good Or Bad. The Quarterly Journal of Economics, 108(4), 941-964. https://www.jstor.org/stable/2118455.
[23] Murphy, Kevin M., and Gary S. Becker (2000). Social Economics: Market Behavior in a Social Environment. The President and Fellows of Harvard College.
[24] Weyl, E. Glen (2019). Price Theory. Journal of Economic Literature, 57(2), 354. https://doi.org/10.1257/jel.20171321.
[25] Becker, G. S. (1971). The Economics of Discrimination (Economic Research Studies) (2nd ed.). University of Chicago Press.
[26] Murphy, K. M. (2015, June 15). How Gary Becker saw the scourge of discrimination. Chicago Booth Review.
https://review.chicagobooth.edu/magazine/winter-2014/how-gary-becker-saw-the-scourge-of-discrimination
[27] Peltzman, S. (1975). The Effects of Automobile Safety Regulation. Journal of Political Economy, 83(4), 677–725. https://doi.org/10.1086/260352
[28] Estimates of Job Creation from the American Recovery and Reinvestment Act of 2009. (2009, May). The White House. https://obamawhitehouse.archives.gov/administration/eop/cea/Estimate-of-Job-Creation/#:%7E:text=The%20American%20Recovery%20and%20Reinvestment%20Act%20(ARRA)%20was%20designed%20to,the%20economy%20as%20a%20whole.
[29] Mulligan, C. B. (2012). The Redistribution Recession: How Labor Market Distortions Contracted the Economy (1st ed.). Oxford University Press.
[30] Mulligan, C. B. (in press). The ARRA: Some Unpleasant Welfare Arithmetic. NBER Working Paper.
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