Price theory Economics definition

May 16, 2016
Economic transactions

This chapter consists of three parts. The first describes and defends some of the fundamental assumptions and definitions used in economics. The second attempts to demonstrate the importance of price theory, in part by giving examples of economic problems where the obvious answer is wrong and the mistake comes from not having a consistent theory of how prices are determined. The third part briefly describes how, in the next few chapters, we are going to create such a theory.


There are a number of features of the economic way of analyzing human behavior that many people find odd or even disturbing. One such feature is the assumption that the different things a person values can all be measured on a single scale, so that even if one thing is much more valuable than another, a sufficiently small amount of the more valuable good is equivalent to some amount of the less valuable. A car, for example, is probably worth much more to you than a bicycle, but a sufficiently small "amount of car" (not a bumper or a headlight but rather the use of a car one day a month, or one chance in a hundred of getting a car) has the same value to you as a whole bicycle-given the choice, you would not care which of them you got.

This sounds plausible enough when we are talking about cars and bicycles, but what about really important things? Does it make sense to say that a human life-as embodied in access to a kidney dialysis machine or the chance to have an essential heart operation-is to be weighed in the same scale as the pleasure of eating a candy bar or watching a television program?

Strange as it may seem, the answer is yes. If we observe how people behave with regard to their own lives, we find that they are willing to make trade-offs between life and quite minor values. One obvious example is someone who smokes even though he believes that smoking reduces life expectancy. Another is the overweight person who is willing to accept an increased chance of a heart attack in exchange for some number of chocolate sundaes.

Even if you neither smoke nor overeat, you still trade off life against other values. Whenever you cross the street, you are (slightly) increasing your chance of being run over. Every time you spend part of your limited income on something that has no effect on your life expectancy, instead of using it for a medical checkup or to add safety equipment to your car, and every time you choose what to eat on any basis other than what food comes closest to the ideal diet a nutritionist would prescribe, you are choosing to give up, in a probabilistic sense, a little life in exchange for something else.

Those who deny that this is how we do and should behave assume implicitly that there is such a thing as enough medical care, that people should (and wise people do) first buy enough medical care and then devote the rest of their resources to other and infinitely less valuable goals. The economist replies that since additional expenditures on medical care produce benefits well past the point at which one's entire income is spent on it, the concept of "enough" as some absolute amount determined by medical science is meaningless. The proper economic concept of enough medical care is that amount such that the improvement in your health from buying more would be worth less to you than the things you would have to give up to pay for it. You are buying too much medical care if you would be better off (as judged by your own preferences) buying less medical care and spending the money on something else.

I have defined enough in terms of money only because the choice you face with regard to the goods and services you buy is whether to give up a dollar's worth of one in exchange for getting another dollar's worth of something else. But market goods and services are only a special case of the general problem of choice. You are buying enough safety when the pleasure you get from running across the street to talk to a friend just balances the value to you of the resulting increase in the chance of getting run over.

So far, I have considered the trade-off between small amounts of life and ordinary amounts of other goods. Perhaps it has occurred to you that we would reach a different conclusion if we considered trading a large amount of life for a (very) large amount of some other good. My argument seems to imply that there should be some price for which you would be willing to let someone kill you!

There is a good reason why most people would be unwilling to sell their entire life for any amount of money or other goods-they would have no way of collecting. Once they are dead, they cannot spend the money. This is evidence not that life is infinitely valuable but that money has no value to a corpse.

Suppose, however, we offer someone a large sum of money in exchange for his agreeing to be killed in a week. It still seems likely he would refuse. One reason (seen from the economist's standpoint) is that as we increase the amount we consume in a given length of time, the value to us of additional amounts decreases. I am very fond of Baskin-Robbins ice cream cones, but if I were consuming them at a rate of a hundred a week, an additional cone would be worth very little to me. I weigh life and the pleasure of eating ice cream on the same scale, yet no quantity of ice cream I can consume in a week is worth as much to me as the rest of my life. That is why, when I initially defined the idea that everything can be measured on a single scale, I put the definition in terms of a comparison between the value of a given amount of the less valuable good and a sufficiently small amount of the more valuable, instead of comparing a given amount of the more valuable to a sufficiently large amount of the less valuable.

Wants or Needs?

The economist's assumption that all (valued) goods are in this sense comparable shows itself in the use of the term wants rather than needs. The word needs suggests things that are infinitely valuable. You need a certain amount of food, clothing, medical care, or whatever. How much you need could presumably be determined by the appropriate expert and has nothing to do with what such things cost or what your particular values are. This is the typical attitude of the noneconomist, and it is why the economist's way of looking at things often seems unrealistic and even ugly. The economist replies that how much of each of these things you will, and should, choose to have depends on how much you value them, how much you value other things you must give up to get them, and how much of such other things you must give up to get a given amount of clothing, medical care, or whatever. Your choices depend, in other words, on your tastes and on the costs to you of the alternative things that you desire.

Trade-Offs in Economics: Definition & Examples
Trade-Offs in Economics: Definition & Examples
What is the Law of Demand in Economics? - Definition & Example
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Prices - Economic Theory
Prices - Economic Theory
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