What Is “Price Theory”? (A Guest Post by Glen Weyl)

by on July 29, 2015 at 7:38 am in Economics, History, Philosophy | Permalink

When I was last living in Chicago, in the spring 2014, a regular visitor to the department of the University of Chicago and the editor of the Journal of Economic Literature, Steven Durlauf, asked me if I would be interested in writing something for the journal. For many years I had promised Gary Becker that I would write something to help clarify the meaning and role of price theory to my generation of economists, especially those with limited exposure to the Chicago environment, which did so much to shape my approach to economics. With Gary’s passing later that spring, I decided to use this opportunity to follow through on that promise. More than a year later I have posted on SSRN the result.

I have an unusual relationship to “price theory”. As far as I know I am the only economist under 40, with the possible exception of my students, who openly identifies myself as focusing my research on price theory. As a result I am constantly asked what the phrase means. Usually colleagues will follow up with their own proposed definitions. My wife even remembers finding me at our wedding reception in a heated debate not about the meaning of marriage, but of price theory.

The most common definition, which emphasizes the connection to Chicago and to models of price-taking in partial equilibrium, doesn’t describe the work of the many prominent economists today who are closely identified with price theory but who are not at Chicago and study a range of different models. It also falls short of describing work by those like Paul Samuelson who were thought of as working on price theory in their time even by rivals like Milton Friedman. Worst of all it consigns price theory to a particular historical period in economic thought and place, making it less relevant to the future of economics.

I therefore have spent many years searching for a definition that I believe works and in the process have drawn on many sources, especially many conversations with Gary Becker and Kevin Murphy on the topic as well as the philosophy of physics and the methodological ideas of Raj Chetty, Peter Diamond and Jim Heckman among others. This process eventually brought me to my own definition of price theory as analysis that reduces rich (e.g. high-dimensional heterogeneity, many individuals) and often incompletely specified models into ‘prices’ sufficient to characterize approximate solutions to simple (e.g. one-dimensional policy) allocative problems. This approach contrasts both with work that tries to completely solve simple models (e.g. game theory) and empirical work that takes measurement of facts as prior to theory. Unlike other definitions, I argue that mine does a good job connecting the use of price theory across a range of fields of microeconomics from international trade to market design, being consistent across history and suggesting productive directions for future research on the topic.

To illustrate my definition I highlight four distinctive characteristics of price theory that follow from this basic philosophy. First, diagrams in price theory are usually used to illustrate simple solutions to rich models, such as the supply and demand diagram, rather than primitives such as indifference curves or statistical relationships. Second, problem sets in price theory tend to ask students to address some allocative or policy question in a loosely-defined model (does the minimum wage always raise employment under monopsony?), rather than solving out completely a simple model or investigating data. Third, measurement in price theory focuses on simple statistics sufficient to answer allocative questions of interest rather than estimating a complete structural model or building inductively from data. Raj Chetty has described these metrics, often prices or elasticities of some sort, as “sufficient statistics”. Finally, price theory tends to have close connections to thermodynamics and sociology, fields that seek simple summaries of complex systems, rather than more deductive (mathematics), individual-focused (psychology) or inductive (clinical epidemiology and history) fields.

I trace the history of price theory from the early nineteenth to the late twentieth when price theory became segregated at Chicago and against the dominant currents in the rest of the profession. For a quarter century following 1980, most of the profession either focused on more complete and fully-solved models (game theory, general equilibrium theory, mechanism design, etc.) or on causal identification. Price theory therefore survived almost exclusively at Chicago, which prided itself on its distinctive approach, even as the rest of the profession migrated away from it.

This situation could not last, however, because price theory is powerfully complementary with the other traditions. One example is work on optimal redistributive taxation. During the 1980’s and 1990’s large empirical literatures developed on the efficiency losses created by income taxation (the elasticity of labor supply) and on wage inequality. At the same time a rich theory literature developed on very simple models of optimal redistributive income taxation. Yet these two literatures were largely disconnected until the work of Emmanuel Saez and other price theorists showed how measurements by empiricists were closely related to the sufficient statistics that characterize some basic properties of optimal income taxation, such as the best linear income tax or the optimal tax rate on top earners.

Yet this was not the end of the story; these price theoretic stimulated empiricists to measure quantities (such as top income inequality and the elasticity of taxable income) more closely connected to the theory and theorists to propose new mechanisms through which taxes impact efficiency which are not summarized correctly by these formulas. This has created a rich and highly productive dialog between price theoretic summaries, empirical measurement of these summaries and more simplistic models that suggest new mechanisms left out of these summaries.

A similar process has occurred in many other fields of microeconomics in the last decade, through the work of, among others, five of the last seven winners of the John Bates Clark medal. Liran Einav and Amy Finkelstein have led this process for the economics of asymmetric information and insurance markets; Raj Chetty for behavioral economics and optimal social insurance; Matt Gentzkow for strategic communication; Costas Arkolakis, Arnaud Costinot and Andrés Rodriguez-Clare in international trade; and Jeremy Bulow and Jon Levin for auction and market design. This important work has shown what a central and complementary tool price theory is in tying together work throughout microeconomics.

Yet the formal tools underlying these price theoretic approximations and summaries have been much less fully developed than have been analytic tools in other areas of economics. When does adding up “consumer surplus” across individuals lead to accurate measurements of social welfare? How much error is created by assumptions of price-taking in the new contexts, like college admissions or voting, to which they are being applied? I highlight some exciting areas for further development of such approximation tools complementary to the burgeoning price theory literature.

Given the broad sweep of this piece, it will likely touch on the interests of many readers of this blog, especially those with a Chicago connection. Your comments are therefore very welcome. If you have any, please email me at glenweyl@microsoft.com.

1 Dana July 29, 2015 at 9:35 am

I think it’s probably a good thing that you were not involved in a debate about the meaning of marriage at your own wedding reception.

2 JWatts July 29, 2015 at 1:53 pm

+3

3 JWatts July 29, 2015 at 1:54 pm

Or 1 + ?1

4 Adrian Ratnapala July 29, 2015 at 2:31 pm

Does 1 + ?1 equal three? Or is it that 1 + (1 +1) = ???!

5 Economist July 29, 2015 at 9:38 am

These words in your definition need further clarification : “incompletely specified models”.

Many (perhaps all) neoclassical models involve (constrained) optimizing behavior of economic agents and some mechanism to ensure that the behavior is consistent. Any such mechanism involves the adjustment of one or more parameters. Typically, those parameters are prices. So is your definition of price theory grounded in the fact that it does not explicit model optimizing behavior and the focus is exclusively on the equilibria and welfare analysis ?

I contend that “price theory” is difficult to define in such a succinct fashion. It is more a culture/world view that combines i) an awareness of economic institutions (and their influence on equilibria) . These include policies and regulations that engender such things as entry barriers and rents. ii) A belief that Marshallian economics can explain the “ordinary business of life”. iii) A belief that markets work better than non-markets (e.g. Smith (1776) or Hayek (1945).

6 Enrique July 29, 2015 at 9:42 am

The abstract on SSRN has the words “neoclassical microeconomics” appear on the first line ,,, doesn’t make me want to read any further

7 mulp July 29, 2015 at 1:48 pm

That would imply price is related to real world value which is based on real world costs of producing a marginal added unit at a cost less than price???

And that would then mean price was not reasonably set very high so you can make huge profits while demanding prices charged to you far below the cost of production, ie, living costs, to give you consumer profit?

8 Brian Donohue July 29, 2015 at 9:57 am

In college, the Econ 200 and 201 text was “Price Theory and Applications” by Hirschlifer. I had Peltzman for Econ 200. Not just brilliant, but a showman, a performer. I attribute a significant percentage of my Fancy U. tuition premium to that class. It’s why I understand economics better than a lot of PhDs.

9 Steven Kopits July 29, 2015 at 10:13 am

I’ll be speaking on oil price formation at the US Energy Economists Association Conference in Pittsburgh Oct. 25-28.

I spend most of my time advising clients–hedge funds and family offices–on oil price trends. If one has any feel for economics, it doesn’t take a long until you find out you’re sorely lacking tools. Some of these I have developed and work pretty well. In other cases, I can see problems but don’t know the solutions.

Here’s more: http://www.prienga.com/blog/2015/7/29/ill-be-presenting-on-oil-price-formation

10 Ray Lopez July 29, 2015 at 10:21 am

@Steven Kopits – what is this post of yours, spam? What’s this got to do with price theory? And what do you think of your competitor Daniel Yergen? He writes a history of the oil industry, and next thing you know he sets up a consultancy claiming he has a crystal ball on the future direction of oil prices. Sound familiar?

11 bartman July 29, 2015 at 12:36 pm

Firstly, CERA was started in 1983, and The Prize was published in 1990.

Secondly, Yergin never made any such claims about a crystal ball. Anybody in the oil forecasting business knows that there is too much uncertainty about the drivers to be able to make reliable price prediction. oil forecasting is all about understanding the underlying drivers of the market, far too few people have a decent understanding of that.

Thirdly, CERA is part of a conglomerate that employs thousands of people in hundreds of offices in dozens of countries, Kopits runs a one-man start-up. They are hardly competitors.

Other than that, you’re absolutely correct on all points.

12 Ray Lopez July 29, 2015 at 12:42 pm

@bartman – thanks, I stand corrected, and vindicated. I can’t figure out how CERA (IHS Cambridge Energy Research Associates) fits into all this, but let’s let it go.

13 bartman July 29, 2015 at 1:28 pm

CERA is the consultancy that Yergin started. You know, the thing you were commenting about in your post. If you can’t figure that out, well, words fail.

14 Steven Kopits July 29, 2015 at 6:07 pm

Dan Yergin is a fine historian and very knowledgeable about the oil industry. He is an excellent presenter. However, he has been notably absent in recent times. I am left under the impression he is semi-retired. When I have seen him recently, he has tended to talk in generalities and not specifics. Yergin has typically avoided price forecasts, as I recall. Really, I think he has historically tended to focus more on supply.

I spend much of my time doing meta-analysis, that is, reviewing the forecasts of independent consultancies and the major investment banks. I provide context, commentary, and my own market views. I have focused on price in recent times, since this is decisive for my clients.

To me, price is not a random walk. It is a language. Nothing is random, everything has cause and effect. I just don’t speak the language that well, and I am trying to speak it better. If you like, we can refer to that ‘language’ as price theory.

15 Ray Lopez July 29, 2015 at 10:23 am

@Dr. Weyl – have you any thoughts on the macro economics “prize puzzle”. I will send you this post by email as well if perchance you don’t read the comments. Below is a blurb to jog your memory. – RL

A fundamental tenet of monetary policymaking is that a surprise increase in the short-term interest rate will lower price inflation from what it otherwise would have been. Thus, it has been disconcerting to macroeconomists that many empir ical estimates of the relationship between the federal funds rate and inflation have suggested that a surprise interest rate hike is followed immediately by a sustained increase in the inflation rate. This result has become known as the “price puzzle,” starting with Eichenbaum (1992). Hanson (2004) showed that it is not easy to explain away the price puzzle, especially in the pre-1980 period. The attached chart highlights circumstances in which the price puzzle flourished; specifically, it shows the tendency of the federal funds rate to precede change in inflation in the same direction during the 1970s.

16 Ray Lopez July 29, 2015 at 12:44 pm

I just got this email by Dr. Weyl: “I have no views on this.”

So there you go, the last word.

17 AR July 29, 2015 at 11:18 am

At Chicago undergrad, Steve Levitt’s “Economics of Crime” best captured the four price-theory characteristics so described. Most economics classes were very price-theoretic but Levitt’s did it best.

18 t-dist July 29, 2015 at 11:27 am

See the Sims (1992) interpretation of the so-called “price puzzle”, the conventional finding in the VAR literature that a contractionary monetary policy shock is followed by a slight increase in the price level, rather than a decrease as standard economic theory would predict. Sims’s explanation for the price puzzle is that it is the result of imperfectly controlling for information that the central bank may have about future inflation. If the Fed systematically tightens policy in anticipation of future inflation, and if these signals of future inflation are not adequately captured by the data series in the VAR, then what appears to the VAR to be a policy shock may in fact be a response of the central bank to new information about inflation. Since the policy response is likely only to partially offset the inflationary pressure, the finding that a policy tightening is followed by rising prices is explained.

19 John July 29, 2015 at 12:08 pm

Sounds like a Keynesian beauty contest, but with rates of interest and inflation. And it sounds like why an economic theory will only capture a portion of our human nature. We aren’t all Marshallian all the time. We go off the reservation and produce Mandelbrot’s misbehaviors at chaotic interval.

20 scott cunningham July 29, 2015 at 12:41 pm

This is a great post, and I look forward to reading the manuscript you referenced. I teach a masters level microeconomics course using Nicholson and Snyder, and I wonder if it might be helpful to see a textbook that is identified with the Chicago tradition of price theory so that I could better understand what truly makes it distinctive. Is there a textbook at the graduate level that you’d recommend reading so I could compare it with other textbooks to get a better understanding of where you’re coming from?

21 weareastrangemonkey July 29, 2015 at 6:38 pm

Becker, Murphy and Weyl don’t/didn’t really use a single text book – not on any of the graduate price theory courses. Part of price theory is taught by Myerson and Reny but its not the really “price theory” part of the price theory course (Reny has a text book http://www.amazon.com/Advanced-Microeconomic-Theory-3rd-Edition/dp/0273731912).

Weyl has all of his lectures online – go to youtube “Weyl price theory”.

I think Becker’s book “Human Capital…” and his book with Murphy “Social Economics” also give a good feel for the “Price Theory” approach.

Then of course, finally, there is Friedman’s textbook “Price Theory”. Which is beautiful in many ways but not suitable as a single textbook for a course.

22 weareastrangemonkey July 29, 2015 at 6:39 pm

If I had read further down I would have seen that Glen has already answered this.

23 Glen Weyl July 29, 2015 at 12:51 pm

I recommend Becker’s “Economic Thoery”

24 Brian Albrecht July 29, 2015 at 1:29 pm

Becker’s last edition of Economic Theory admits the text is years behind compared to the course that he and Murphy taught, specifically mentioning the topic of choice under uncertainty. Is there a recent set of lecture notes that captures “2015” price theory?

Maybe a different way to think about it: if you were teaching grad price theory, would your references be Becker and then modern articles you mention in the paper?

25 Glen Weyl July 29, 2015 at 2:33 pm

My price theory and market design course is a few years out of date, but is in the ballpark:
http://glenweyl.com/teaching/

26 mulp July 29, 2015 at 2:10 pm

I find any discussion of price theory that does not start with value based on cost to be an example of the attempts of economists to shed the “dismal science” label.

Look, we have a theory that says you can pick up any rock and sell it for $10 as a pet, so we offer you the free lunch of making money without (much) work!

Or in the Internet era, you register pets.com for $20 and then IPO and create three hundred million dollars in “wealth” based on the price of the shares while setting the price of the products you sold at the price theory 70% of the cost to buy them and then pay more to provide free delivery.

This is the same theory domain that argues the fair price for labor can be $10,000 below the cost of living, food, clothing, and required car to get the job, and that it is the worker who is to blame for not buying a house, good clothes, and a new car but instead is homeless living in a car that does not run and eating out of dumpster.

27 John July 29, 2015 at 2:25 pm

Don’t forget, there can be zero marginal product labor, but never zero marginal product jobs!

28 Demosthenes July 29, 2015 at 5:22 pm

There’s something fundamentally inconsistent in trying to write the history of something you’re simultaneously constructing.

29 _NL July 30, 2015 at 2:19 pm

So the all-important definition is a jargon-dense sentence fragment buried in the middle of the fourth paragraph.

As a non-economist, I think it means what I would’ve expected the definition to be (something like “the study of reducing a large volume of information into one cost number”). Maybe it could’ve been stated more simply and presented more prominently? If the goal is communicating the definition of price theory, I mean.

30 jacob July 31, 2015 at 3:08 pm
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