What Should Economists Do? Price Theory or Microeconomics?
In his 1963 Presidential Address to the Southern Economic Association, later published as “What Should Economists Do?”, James Buchanan called for “economists to modify their thought processes, to look at the same phenomena through ‘another window,’ to use Nietzsche’s appropriate metaphor. I want them to concentrate on ‘exchange’ rather than on ‘choice’” (1964, p. 217). The notion that economic theory is a “window” is a very appropriate metaphor, particularly when economists come to different conclusions from observing the same phenomenon. Thus, alternative conceptualizations of economic theory serve as different “windows” from which the economists draws different conclusions about the world, particularly how markets work.
Just as Buchanan often used this metaphor from Nietzsche, I wish to adopt it here to draw an important distinction between “price theory” and “microeconomics,” which are often conflated. Although the distinction may seem to be one of semantics, in these posts I will explain and illustrate the subtle differences between the two which have important implications about what we “see” when markets operate, and the extent to which we conclude whether markets “work” or “fail.” Just as the same individual will observe different aspects of the same automobile traffic from different windows of a building, we draw different conclusions about a particular market based simply on whether we are looking from the window of “price theory” or “microeconomics.”
What is the distinction between the two? As Buchanan suggested above, “price theory” is primarily about the study of how individuals pursue their separate goals through exchange, which in turn create exchange ratios (i.e. market prices) as by-products of their purposive behavior. Such market prices, in turn, guide individuals in their consumption and production decision-making. Human choice is not absent in price theory; rather, it is a necessary subset of price theory, though not sufficient, for understanding the invisible hand processes that generate social order. Nor does price theory imply that markets allocate resources instantaneously according to omniscient human actors. Rather, a price-theoretic approach to economic theory is one in which there is an indirect link between a human agent and the tendency towards equilibrium, one in which market outcomes are not directly reducible to the individuals that constitute a market.
That is, prices emerge from the act of exchange between individuals engaging in open-ended choice under a world of uncertainty, but not of human design. However, once emerged, prices then become guides for future action. Thus, whether markets “work” or “fail” does not depend on the behavioral characteristics of individuals, but whether institutions secure and enforce the ability for individuals to exchange (i.e. private property). A “market failure” in this respect is not a failure of markets to “work” but a failure to establish the conditions for a market to exist, unleashing future profit opportunities to establish such conditions.
Moreover, it is not enough for prices to reflect full and available information quickly, as suggested by the efficient market hypothesis; real-world market prices are not sufficient statistics to approximate an allocation of resources consistent with equilibrium. Rather, market prices must translate the tacit and dispersed knowledge of millions of individuals into publicly held information correctly (see Boettke 2012, 2018).
As the famed value investor, Howard Marks, makes this point, market prices are “efficient” in “the sense of ‘speedy, quick to incorporate information,’ not ‘right’.” (2011, p. 8). Thus, although not immediately obvious by its epithet, price theory crucially depends on the study of non-price competition. As Harold Demsetz argues, “[m]arket processes work neither instantaneously nor with full knowledge, so perfect competition hardly exhausts the many ways in which self-interest is pursued. Competing through product quality, contractual arrangements, and institutional innovation, and through tactical quickness and alertness, all become meaningful” (1982, p. 18). Price theory, properly understood, is a window from which to understand how individuals are able to learn how to cooperate with one another without command under a division of labor. Such “cooperation”, counterintuitively, is manifested in a peaceful and cooperative form of cooperation: productive specialization and exchange.
Tomorrow, I will consider how this theoretical “window” compares to microeconomics.
Rosolino Candela is a Senior Fellow in the F.A. Hayek Program for Advanced Study in Philosophy, Politics, and Economics, and a Program Director of Academic and Student Programs at the Mercatus Center at George Mason University.
Richard W Fulmer
Mar 14 2023 at 3:37pm
And they must do so despite myriad distortions such as currency manipulation, price controls, tariffs, taxes, subsidies, quotas, licenses, regulations, and monopoly and antitrust laws. When markets “fail” to deal with such distortions, the failure is typically blamed on “unfettered” capitalism and is used to justify more interventions.
Mar 14 2023 at 8:49pm
Thank you, sir, and looking forward to your explanation of the differences between price theory and microeconomics.
Dr. Henderson has previously stated the following:
But aren’t there several topics in micro (for example utility theory) that have nothing to do with price? Isn’t price theory more limited in scope? In other words, couldn’t one master price theory by mastering micro, but not the other way around?
Mar 15 2023 at 12:13pm
Thank you, sir, for reading! I really appreciate it.
This post is part of a larger essay being released in three parts. The second part has been released today, and hopefully reading it (and the third part) will address this very important question: https://www.econlib.org/choosing-among-lemons
Mar 17 2023 at 4:33pm
Price theory is the fundamental principle of microeconomics. Without understanding how prices formed you cannot understand other subjects of microeconomics.
I recommend you this short paper;
Mar 17 2023 at 4:29pm
Prices are the basic principles of microeconomics.
You value so many things to price theory. However, it is fundamentally linked to monetary system which is a field hardly anyone understands.
I recommend you to read this short paper I just recently wrote that explains how prices formed. First (microeconomics) part is enough to understand price theory.
Thomas Lee Hutcheson
Mar 17 2023 at 10:02pm
This window seems to make it difficult to detect markets that do not exist (e.g. for net CO2 emissions) or for worrying about the income distribution consequences of the prices and quantities transacted.