Price Theory

Milton Friedman

• Publisher: Routledge
• Year: 2017
• ISBN:
  9781351496773
• Edition: 1
• Topic: Betriebswirtschaft
• Subtopic: Business allgemein

Economics is sometimes divided into two parts: positive economics and normative economics. The former deals with how the economic problem is solved, while the latter deals with how the economic problem should be solved. The effects of price or rent control on the distribution of income are problems of positive economics. The desirability of these effects on income distribution is a problem of normative economics.

Within economics, the major division is between monetary theory and price theory. Monetary theory deals with the level of prices in general, with cyclical and other fluctuations in total output, total employment, and the like. Price theory deals with the allocation of resources among different uses, the price of one item relative to another.

Prices do three kinds of things. They transmit information, they provide an incentive to users of resources to be guided by this information, and they provide an incentive to owners of resources to follow this information. Milton Friedman's classic book provides the theoretical underpinning for and understanding of prices.

Economics is not concerned solely with economic problems. It is a social science, and is therefore concerned primarily with those economic problems whose solutions involve the cooperation and interaction of different individuals. It is concerned with problems involving a single individual only insofar as the individual's behavior has implications for or effects upon other individuals. Price Theory is concerned not with economic problems in the abstract, but with how a particular society solves its economic problems.

1

Introduction

These notes deal with price theory. The larger part is devoted to the pricing of final products;” the rest, to the theory of distribution. The reason for devoting more attention to the pricing of final products is that the theory of distribution is a special case of the theory of pricing, concerned with the pricing of factors of production. Hence, the principles that explain prices in the product markets also explain prices in the factor markets.

Meaning of Economics: Economic Theory

Economics is the science of how a particular society solves its economic problems. An economic problem exists whenever scarce means are used to satisfy alternative ends. If the means are not scarce, there is no problem at all; there is Nirvana. If the means are scarce but there is only a single end, the problem of how to use the means is a technological problem. No value judgments enter into its solution, only knowledge of physical and technical relationships. For example, suppose given amounts of iron, labor, etc. are available and are to be used to build an engine of maximum horsepower. This is a purely technical problem that requires knowledge solely of engineering and of physical science. Alternatively, let the objective be to build the “best” engine, where the concept of “best” involves not only horsepower, but also weight, size, etc. There is no longer a single end. No amount of purely physical and technical knowledge can yield a solution, since such knowledge cannot tell you how much power it is “worth” sacrificing to save a certain amount of weight. This is an economic problem, involving value judgments.

This concept of an economic problem is a very general one and goes beyond matters ordinarily thought of as belonging to economics. For example, according to this conception an individual is dealing with an economic problem when he decides how to allocate his leisure time between alternative uses. Indeed, strictly speaking there is hardly any problem that is purely technological. Even in the cases cited above, the engineer building the engine will have alternative ends, thinking about other things, making his work pleasant, etc., and these will affect his decision about how hard to work on the stated technological problem. This concept of an economic problem is also broad in the sense that it covers equally the problems in a Robinson Crusoe economy, in a backward agricultural economy, or in a modern industrial society.

Economics, by our definition, is not concerned with all economic problems. It is a social science, and is therefore concerned primarily with those economic problems whose solutions involve the cooperation and interaction of different individuals. It is concerned with problems involving a single individual only insofar as the individual’s behavior has implications for or effects upon other individuals. Furthermore, it is concerned not with the economic problem in the abstract, but with how a particular society solves its economic problems. Formally, the economic problem is the same for a Robinson Crusoe economy, a backward agricultural economy, a modern industrial society organized on a communistic basis, and a modern industrial society organized on a capitalistic basis. But these different societies use different institutional arrangements to solve their economic problems. Thus there is need for a different economics—or a different chapter in economics—for each kind of society. There turns out, in fact, to be much that is common to the various chapters, but this cannot be required in advance; it is, rather, one of the conclusions of economic science.

Our definition of economics can be viewed as something of a compromise between a completely general definition of the economic problem and an opposing desire for concreteness of application.

How does this definition of economics distinguish it from other subjects of study?

The emphasis on “alternative” ends, which introduces value judgments, distinguishes it from the technological and physical sciences, which are concerned with the relation between scarce resources and single ends. The acceptance of the ends as given distinguishes it from psychology, which deals with the formation of preferences, and from ethics, which deals with the evaluation of preferences.

The most difficult line to draw is between economics and political science. Certainly governmental institutions of the kind studied by political science are means whereby a particular society uses scarce means to satisfy alternative ends. The title of a well-known book by Harold Lasswell is Politics: Who gets What, When, How. Replace politics by economics and the title would clearly be equally appropriate—yet the book so labelled would be altogether different.

Or consider Alfred Marshall’s definition of economics: “A Study of mankind in the ordinary business of life; it examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of well-being.” In the Great Britain of Alfred Marshall’s day, this definition may have served rather well. But today, when the government plays so large a role in the attainment and the use of the “material requisites of well-being,” it too does not distinguish between economics and political science.

More fundamentally, Marshall’s definition implies that the fundamental difference between the two disciplines is in the character of the ends pursued, that economics is concerned with the “material requisites” and other disciplines with the “immaterial” requisites. But this is not a satisfactory criterion. Economics has as much to say about the use of resources for art, literature, theater, schooling, and other aspects of the “immaterial” requisites as for the material requisites. And clearly, governmental agricultural policies deal with ‘‘material” requisites.

A more satisfactory criterion is the means of organization studied, economics being mainly concerned with market mechanisms of purchase and sale as devices for organizing the use of resources. Political science is mainly concerned with mechanisms involving commands, whether by a constituted authority or by explicit voting. But even this distinction is much less than fully satisfactory. Economics has much to say about the consequences of different sets of commands; political science has to encompass governmental interventions into market arrangements.

This difficulty in drawing a dividing line has had consequences. One of the most stimulating developments in the two disciplines since the early 1960s has been the use of economic tools to analyze political arrangements. This merging of the two disciplines has been the work of both economists and political scientists: Downs, Dahl, Stigler, Buchanan, Tullock, to mention just a few of the most prominent names.

Four Economic Sectors

To return to the emphasis on “a particular society” in the definition of economics that I have given, differences in the institutional arrangements that are used to solve economic problems can be illustrated by reference to our own society. One may think of our society as consisting of four sectors, each using a conceptually different arrangement: the government sector, the household sector, the sector consisting of nonprofit institutions, and the market sector.

In every society, whether the U.S. or the U.S.S.R., a substantial fraction of all resources, probably more than half, are used in the household sector. The major resource in all societies is human productive capacity—human capital as it has come to be called—and most of our time and energy is spent, not in productive activities organized through the market or by the command of governmental authorities but in activities within the household. In addition, much physical capital—from owned homes to kitchen equipment to clothes—is utilized within the household sector. Most of these uses of resources raise no social problem, at least not for economics. Yet there are many interactions between the household sector and the market sector.

One of the important interactions arises out of shifts of activities to and from the household. Such shifts affect, among other things, the validity of estimates of national income as measures of growth. For example, the steady decline in average hours of employment has meant that the growth of measured national income understates the growth of total output because it excludes the value of the additional leisure. On the other hand, the transfer of many activities, such as food preparation and laundering, from the household to the market has had the opposite effect.

In recent decades, there has been an increasing use of economic analysis to interpret behavior in the household that was traditionally excluded from the realm of economics. Gary Becker’s pioneering work in this direction deserves special mention.

The principle of organization operating in the household is similar to that employed in a collectivist society—central authority. The major difference is that participation in the household is voluntary for adults. But even this difference does not exist for children.

The government sector has clearly been growing rapidly in the U.S. and in most other Western countries. In the U.S., spending by state, local, and federal governments, after being roughly stable as a percentage of net national product for a century or more except for major wars, has risen from roughly 10 percent of net national product in 1929 to 20 percent in 1940, to 23 percent in 1950, to 30 percent in 1960, to 35 percent in 1970. These numbers in some ways overstate the role of government, in others, understate it. They overstate it because much of the expenditure simply transfers control of resources from some people to others (e.g., welfare expenditures) rather than uses resources directly (e.g., highway construction). They understate it because governmental actions that have significant effects on the economy may involve negligible expenditures (e.g., import quotas, minimum wage rates, I.C.C., antitrust).

Because so large a fraction of the government’s activities are carried out through the market or impinge on the market, the growth of the government sector has not reduced the relevance of the price theory presented in this book. Indeed, this theory has proved highly relevant not only to the government sector in a “mixed” economy like the U.S. but also to the operation of a supposedly wholly government economy like the U.S.S.R. In practice, even though the basic organizing principle of such an economy may be central authority, every such economy has found it necessary to put extensive reliance on market mechanisms for organizing resources.

The nonprofit sector is the smallest of the four sectors in the U.S. economy. It consists of such institutions as universities, churches, museums, nonprofit hospitals, but also of mutual insurance companies, mutual savings banks, cooperative grocery stores. The characteristic feature of the nonprofit sector is that the persons in charge of such institutions exercise authority not as agents for “owners” or as representatives of the body politic in general but as “trustees” either for a purpose (as in a university or church) or for a self-constituted group (such as policyholders of an insurance company). Of course, in many cases the nonprofit form is simply adopted as a tax-evasion device. In any event, the nonprofit sector operates, at least in Western countries, primarily through the market.

The market sector thus overlaps all the other sectors. The fundamental principle of the market sector is the use of purchase and sale to organize the use of resources.

In a “pure” market economy, cooperation among individuals is achieved entirely through voluntary exchange. In its simplest form, such an economy consists of a number of individual households—a collection of Robinson Crusoes, as it were. Each household uses the resources it controls to produce goods and services that it exchanges for goods and services produced by other households, on terms mutually acceptable to the two parties to the bargain. It is thereby enabled to satisfy its wants indirectly by producing goods and services for others, rather than directly by producing goods for its own immediate use. The incentive for adopting this indirect route is, of course, the increased product made possible by division of labor and specialization of function. Since the household always has the alternative of producing directly for itself, it need not enter into any exchange unless it benefits from it. Hence, no exchange will take place unless both parties do benefit from it. Cooperation is thereby achieved without coercion.

Specialization of function and division of labor would not go far if the ultimate productive unit were the household. In a modern society, we have gone much farther. We have introduced enterprises that serve as intermediaries between individuals in their capacities as suppliers of services and as purchasers of goods. We have introduced money to facilitate exchange and avoid barter, thereby enabling the acts of purchase and sale to be separated into two parts.

The introduction of enterprises and money does not change the fundamental principle of a market system, but it does introduce complications that are the main subject matter of price theory and also monetary theory. A more fundamental change is introduced by the mixing of the market sector with the other sectors, particularly the governmental sector. Many of the most subtle and interesting applications of price theory involve analyzing the effect of various governmental interventions.

Both Russia and the United States can be described as enterprise money exchange economies. In both countries, the bulk of the resources outside the household sector are used in enterprises that acquire the use of resources by purchase for money and distribute the bulk of the output by sale for money. The key difference is that in Russia almost all enterprises are public or governmental; in the U.S., most are private, in the sense that the residual income recipient—the body or persons entitled to receive or required to pay any differences between receipts from sales and expenditures on the purchase of resources—is the body politic in the U.S.S.R., identifiable private individuals in the U.S.¹

The difference I have stressed between the character of the enterprises is not identical with the difference that is often regarded as critical—that there is “private property” in the U.S., “public property” in the U.S.S.R. In both countries, the bulk of property, defined broadly to include human productive capacity, is privately owned. Neither is the difference between the U.S. and the U.S.S.R. that individuals, including managers of enterprises, act in their private interest in the U.S. and in the public interest in the U.S.S.R. In both countries, individuals act primarily in their own interest, fairly narrowly defined.² The difference is that the character of the ultimate residual income recipient alters the rewards and sanctions associated with various actions and thus changes what it is in the self-interest of people to do. To illustrate in a dramatic way: the manager of both a U.S. and a Russian factory must take into account the possibility of being discharged for alleged mismanagement, but the Russian manager must also take into account the possibility of being shot.

Private enterprise exchange economies also differ widely. Perhaps the key difference for purposes of price theory is in the conditions that must be met for establishing an enterprise. At the one extreme, establishing an enterprise requires government permission that is more than a formality (as, for example, is true in the U.S. in banking, generation of power, and many other areas). At the other extreme, anyone is free to establish an enterprise without special governmental permission (as, for example, is true in the U.S. for most retail trade, manufacturing, etc.).

The notion of free in the term free enterprise should be interpreted as the freedom to set up an enterprise rather than the freedom to do anything one wishes with his enterprise, including preventing others from setting up enterprises.

Distinctions in Economic Theory

Economics is sometimes divided into two parts: positive economics and normative economics. The former deals with how the economic problem is solved; the latter deals with how the economic problem should be solved. For example, the effects of price or rent control on the distribution of income are problems of positive economics. On the other hand, the desirability of these effects on income distribution is a problem of normative economics. This course deals solely with positive economics.

Within positive economics, the major division is between monetary theory and price theory. Monetary theory deals with the level of prices in general, with cyclical and other fluctuations in total output, total employment, and the like. Price theory deals with the allocation of resources among different uses, the price of one item relative to another. The division between the two main branches of theory is not dictated by a priori considerations but reflects the empirical generalization—which is at least two centuries old—that the factors determining the level of prices and of economic activity can be regarded as largely distinct from those determining relative prices and the allocation of resources. Of course, the two sets of factors overlap, but for most problems the overlap is treated as sufficiently small to be neglected.

Professional jargon has come to designate monetary theory as macroeconomics, price theory as microeconomics. This usage is unfortunate because it gives the misleading impression that monetary theory is concerned with things in the large (macro); price theory, with things in the small (micro). Both branches of theory are concerned primarily to understand things in the large: for example, “the” price level, for monetary theory; “the” relative price of wheat or copper, for price theory. Both branches of theory analyze things in the small to further their understanding of things in the large: for example, the demand for cash balances by the individual holder of money, for monetary theory; the demand for bread or coffee utensils by the individual household, for price theory.

This book deals entirely with price theory.

Economic theory, like all theory, may be thought o...

Table of contents

• Cover
• Title Page
• Copyright Page
• Table of Contents
• AldineTransaction Introduction
• Preface
• Preface to Price Theory: A Provisional Text
• 1 Introduction
• 2 Theory of Demand
• 3 The “Welfare” Effects of Taxes
• 4 The Utility Analysis of Uncertainty
• 5 The Relationships Between Supply Curves and Cost Curves
• 6 The Law of Variable Proportions and a Firm’s Cost Curves
• 7 Derived Demand
• 8 The Theory of Distribution with Fixed Proportions
• 9 The Theory of Marginal Productivity and the Demand for Factors of Production
• 10 Marginal Productivity Analysis: Some General Issues
• 11 The Supply of Factors of Production
• 12 Wage Determination and Unemployment
• 13 Wages in Different Occupations
• 14 Relation Between the Functional and Personal Distribution of Income
• 15 The Size Distribution of Income
• 16 Profits
• 17 The Theory of Capital and the Rate of Interest
• Appendix
• Index