Friday, July 10, 2009

Price and Rationality

One of the most fundamental assumptions in economics is the assumption of rationality - that economic actors are making rational decisions - comparing costs and benefits and searching for the lowest price. Notice I said lowest price, not lowest opportunity cost. That's something I will return to.

First, thanks to Arts & Letters Daily, I ran across this review by Janet Maslin in The New York Times. In the review, the author compares two books - Free by Chris Anderson, and Cheap by Ellen Ruppel Shell.

It appears that Ms. Maslin is not enamored of either book, but both provide an interesting place to start a conversation. While I've not read either book, I have heard interviews with both authors. Anderson was interviewed by Russ Roberts on EconTalk, and Ms. Shell was interviewed on National Public Radio's Talk of the Nation yesterday.

I won't get into issues with normative vs. positive economics. Some of the quoted data is selective. This is to be expected. What moved me to this post is an observation that it boils down to choices and institutions. How our values are shaped, or for this discussion, how our perception of value is shaped by the institutions - the rules, whether formal or informal, that help us shape the choice. Those institutions, whether laws or personal beliefs, help us determine our true opportunity cost. By factoring our personal incentives into a decision, we arrive at a more extensive decision-making matrix. Thus we have a more complete understanding of our true opportunity cost. And we make better choices for ourselves.

As a final point, we should remember that price demonstrates one of the basic functions of money in an economy - that of "a measure of value." It may help to think of it this way - price provides a common language to facilitate decision-making. However, we still have to translate that language into our personal value system, within the context of our wants and needs. It is a measure of value, not the measure of value.

I would recommend spending a little time on this issue. The New York Times review is a good place to start. The podcast interviews can also provide you with some insights. And the books may provide you with more mental fodder.

I welcome your comments, particularly if you've read either or both books.

This post references the following Keystone Economic Principles:
1. We all make choices.
2. There ain't no such thing as a free lunch.
3. All choices have consequences.

4. Economic systems influence choices.
7. Economic thinking is marginal thinking.
9. Prices are determined by the market forces of supply and demand… and are constantly changing.

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