Why micro economy is called price theory
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Most people’s understanding of prices come from their personal experiences with purchasing goods and services, so most people think of “prices” as the amount of money you pay when you want to buy something. From an economist’s point of view, however, prices merely express the relative value of things, and in this sense, prices determine how people will exchange resources. Because microeconomics is fundamentally concerned with how markets perform in the allocation of resources through voluntary exchange, it has gone by the name of price theory.
When I say that prices express the relative value of things, I mean that the price of a particular good can only be defined relative to everything else. If there was one hypothetical good in the whole economy, then we would have zero need for prices because the only way to define its value would be to say it is worth “x” amount of some arbitrary unit. It’s like how a meter is only a meter because we say it is. At the end of the day, a meter merely expresses one way to describe a given distance in space, and if there was only one good in the economy, a price would just describe the amount of that particular good. It would have zero purpose in helping us determine how people will exchange resources. In fact, under mild assumptions, people would never participate in markets if there was only one good!
Now, if we live in a multi-good economy, then prices are useful because they can help us determine the relative value of goods, given the preferences of the people inhabiting the economy. For simplicity, suppose there exist goods A and B with respective prices pA and pB. In a perfect frictionless economy, pA will be entirely determined by how much people prefer A relative to B. In fact, we can even arbitrarily set pB=1, and we can find pA relative to that. The natural corollary of this observation is that there exist infinitely many possible combinations of prices that would produce the same allocation of goods (just set pB to any positive number). This idea also applies in the real world: money is the good whose price has been set to one.
Mainstream economics is fundamentally based on this view of the world. When people make economic decisions, they are always performing some kind of analysis where they evaluate the benefit of one choice relative to another. Even if people make “irrational” consumption decisions, this just means that the cost to considering other choices is not significant enough to merit a more “rational” evaluation. Because people make decisions by comparing possible choices, they have some kind of internal metric about the relative value of those choices. Prices are the external realization of these relative valuations within a market economy such that demand equals supply. Therefore, when we consider how society could allocate resources, we want to think about the price that applies to a particular allocative decision because that price will adjust people’s relative valuations.
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