All economic systems, whether markets, socialist, tribal, even Robinson Crusoe, must do three things.
- Produce certain goods- As Rothbard explained, there are always multiple goods to produce, even with the same inputs. Every good that is produced means that another good was not. This is the opportunity cost.
- Produce goods in a certain way- There are multiple ways to produce any good. Each economic system must have a procedure for determining the method of production.
- Divide goods in a specific way- Once produced, they goods must be allocated to individuals.
In this chapter and throughout most of the book, Stigler addresses how an enterprise economy completes these tasks. Stigler only defines an enterprise economy as the basic essential of Western societies over the last two hundred years. The economy can also be called a market as in Mas-Colell.)
In an enterprise economy, a decentralized process-not specific people- accomplishes the three required tasks. The Theory of Price is an attempted to explain this process.
A market economy consists of two parts, produces and consumers. Stigler calls them business firms and households, respectively. Of course, many households produce and all firms consume. However, to simplify the analysis, they are separate. There are also additional parts, such as governments and other organization, which do not fall into either category. Stigler ignores these complications for the moment.
Even with these assumptions, the three problems above are massive. How does an enterprise economy, such as the US with roughly 10^8 households, thrice as many consumers, and 10^7 business firms. They are producing, allocating, and consuming many different goods and services. It is difficult to estimate this number. Are all hamburgers one type of good or are McDonald's burgers different from Burger King. There is no real answer.
Fortunately, in an enterprise system, prices direct the three problems above for such a decentralized system. These prices, while fallible, are remarkably effective as directing the messages of production and consumption.
Prices signal the willingness to part from or acquire goods through offers made when buying and selling. Economists like to say every consumer and producer votes for goods and services through this buying and selling. Although, unlike a political vote, these votes occur constantly and about one particular issue at a time. Consumers do not vote whether they want Budweiser of Miller for the next for years, only for the next can (or keg). Consumers can even vote none of the above. Producers make a similar vote. They are the two sides to every transaction. As Stigler says
"there is a deep symmetry between buying and selling and the economy theory of the two is identical." (Emphasis added.)
As stated above, these goods often have many uses. Even the most primitive societies could produce many more goods than they do, even ignoring technology advancements. I could use my labor to make paintings. However, prices create an incentive for consumption and production. Since no customer is willing to pay for my paintings, I have an incentive to not use my labor for painting, but something else.
The consumption side is identical. Consumers have an incentive to buy goods that at in abundance relative to demand. Eat raspberries in the summer; ice-skate in the winter. The prices convey the relative abundance or shortage and encourage producers and consumers to act accordingly.
People respond to these incentives. Every consumer is looking for the cheapest price. Every producer is looking for the dearest price. Price theory does not claim that price is the only reason in decisions. It is an incentive to economize effectively.
People do not enjoy the scarcity that high prices convey. As soon as the price of gasoline goes up, people are mad at the prices. Stigler rightly compares this to being blaming the thermometer for it being 90 degrees. The prices convey the underlying abundance and scarcity.
For economists who fail to understand the roles of prices, a lot of them, this chapter is an important start to the study of microeconomics. Prices are powerful signals and incentives. It is impossible to understand an enterprise economy until comprehending the price structure. However, Stigler correctly warns that prices are fallible, especially when incorporating future supply and demand. The scarcity reported by high prices can be created to raise prices. This monopoly theory is the heart of monopoly theory.
While prices are powerful, they are part of a small part of exchanges. Price theory, obviously, focuses on prices. However, it is narrowly applicable (a negative characteristic according to Stigler) compared to a theory based on action like Rothbard or preferences like Mas-Colell. That will weigh against the accuracy of its predictions.