The Uses of Price Theory

I want to go back and discuss more a post I had a few weeks ago on the difference between a model and real life.

As the question highlighted in the post shows, the model and reality can differ.  In the price theory model discussed, there is no deadweight loss from a price ceiling when supply is perfectly inelastic.  However, a more robust consideration tells us there are inefficiencies we need to consider.  A simple observation of the grocery store is another example: if standard price theory were 100% accurate, then supermarket shelves would always be stocked with just enough of each good to meet demand, no more and no less.  But this is clearly not the case.

This difference between the model and reality can lead us to the question: why have models at all?  Indeed, there are some forms of economics that do-away with models and theory altogether preferring to “let the data speak for itself.”

But price theory models serve an extremely important purpose.  Careful study of price theory provides the good economist with strong intuition about the “economic way of thinking.”  Careful study of supply and demand curves can reveal a lot.

Even if these price theory models do not model the world perfectly (and it is my opinion that they do not, although do provide a pretty decent approximation), then the models can still provide valuable insight.  Even though equilibrium is not a point that can ever truly be reached because the economy is dynamic and thus constantly changing, it provides us a good starting point for economic investigations.

Static price theory analysis (that is, all else held equal, including time) provides us many insights into the effects of monopolies, oligopolies, price manipulations (taxation, ceilings, floors, etc), market misinformation, etc.  But it is just that: static.  Adding a dynamic element to price theory makes it far more robust and interesting.  For example: What happens when there are price manipulations over time?  How do demand curves and supply curves shift over time?

But static analysis has its uses, namely that it provides strong intuition.  Intuition that can help answer questions like:

-Does minimum wage help the poor?

-Do anti-discriminatory laws protect women and minorities?

-Will tariffs “make America great again”?

Price theory intuition extends well beyond just the narrow world of “material” well-being.  Jack Hirshleifer has used price theory to explore conflict theory.  Terry Anderson and Donald Leal have applied price theory to environmental issues.  Armen Alchian and Harold Demsetz used price theory to explore discrimination and the development of property rights.  More famously, Gordon Tullock and Ronald Coase used price theory to explore the law and externalities.

Price theory is an extremely powerful tool, even in its static form.  It merits careful study and consideration because there are a lot of subtleties to it, but the logic of price theory is straight forward (unlike macroeconomics).

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