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Introduction to Price Theory, Part 4: Opportunity Cost and Subjectivism

September 11, 2012

Let’s start with a good, say, apples, and take every person in an economy and write down a list of how much they are willing to pay for for an apple. And what determines their willingness to pay? Because at some price, they have a better use for the money. If apples are 5 cents, people will buy them if they don’t have a better use for 5 cents. But if apples are $100, there’s a lot more you can do with $100. So as prices go up, the alternatives to buying apples look better and better. Maybe there’s an apple loving millionaire who is willing to spend $100. So we write down the first data point (1, $100). The next person loves apples, but not so much: (2, $50). And we keep writing down our ordered list of people who want apples, until we’ve written down everyone in the entire economy who wants an apple at any price. Because it’s a sorted list, and because of diminishing returns for individuals, it is always descending. And now, we’ve got a demand curve.

The supply curve represents the cost per unit of bringing a certain quantity of a good to the market. But those costs themselves are determined by supply and demand for factors of production. A firm’s willingness to pay for factors of production depends on the demand for what they can make using those factors. A firm’s willingness to pay for land, fertilizer, workers, etc. depends on the demand for apples. A firm is willing buy factors of production so long as the goods they can produce with those factors are worth more than the total cost of the factors. You can keep going recursively, and look at the people making capital goods, which are demanded because of the final goods which they can help produce. At the end of this process, you are left with only natural resources and human effort. So the costs which make up the supply curve are in fact simply upside down demand curves for the other goods which the factors of production could otherwise have made. Supply and demand is fundamentally a framing of the idea of opportunity cost. Making one thing means you can’t make something else with those same scarce resources. It’s opportunity cost all the way down.

Let’s walk through an example of an apple farm. A farmer can sell apples for $1, which is determined by the subjective value which consumers place on apples. He must hire workers to pick the apples. Those workers can produce many different things, such as pears, or houses, or clothes. The demand for other things determines the best alternative they have to working at an apple farm. If a tailor were willing to hire the worker at $10 an hour to make clothes, the farmer would have to pay $10.01 to convince them to pick fruit (plus compensating differentials). The farm land used to grow apples gets its price from the value which could be produced by using it to grow other crops. If corn farmers could use the land to make more money growing corn, the apple farmer’s economically rational option is to sell the land to the corn farmer, or grow corn himself. Even the value of the farmer’s own time is determined by what other things he could do with it.

Markets are incredible institutions for making relative value judgments by aggregating the subjective values that people place on a nearly infinite number of goods and services and allocating factors of production based on those value judgments. I first really grokked how they worked while reading about the socialist calculation debate. Socialists debated against free market economists over whether a centrally planned economy could get prices and resource allocation “right”. Capitalism was seen as inherently unstable, with financial crises and mass unemployment from time to time. If socialism could allocate resources without that instability, it would be great for humanity. However, because central planners don’t have information either on the value which people place on various goods or on the alternate uses to which factors of production can be put, they can’t allocate either goods or production efficiently. In practice, socialist economies usually copied prices from similar capitalist prices. There was a joke that even if the Soviets conquered the entire world, they’d need at least one capitalist country so they’d know the price of milk. There’s another story about how in the Soviet Union, if factory managers were rewarded by how many nails they produced, they would make tiny pin-like nails. If they were rewarded by weight, they would make fewer huge nails. But even if the nail factory workers produced in good faith, they still wouldn’t know which types of nails were produced without prices to signal which nails were most valued by consumers. I think it goes to show that it is extremely hard to improve a system which you don’t understand.

Further Reading:
Kling on Subjectivisim

6 Comments leave one →
  1. Locke permalink
    September 11, 2012 9:33 pm

    Are supply and demand curves the map, or the territory?

  2. September 12, 2012 5:47 pm

    I’m not sure I really understand what you are asking. Reality is reality. To find out what’s really going on, you have to “look out the window” and observe things. All stories that economists tell, all the models we create, and all the graphs we draw, are all maps/simplifications. But that makes them more useful, not less. Supply and demand helps people explain what is going on without being overwhelmed by it. It helps policymakers come up with good policies without having to reexamine each market anew, etc.

    • Locke permalink
      September 12, 2012 6:28 pm

      Fair enough. I’ll wait for part 5

      • September 12, 2012 7:27 pm

        It might be awhile. I originally didn’t plan on doing a part 4. Is there anything about price theory or supply and demand that you’d like to know?

        Update: If you’re asking how useful supply and demand is, I think it is *the best model* in all economics. Bar none. If there were one thing I could teach everyone about economics, it would be supply and demand.

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