What’s in a Price?

Have you ever thought that it would be nice to get through a bit more of the novel you’ve been reading but you’d rather not pay two cents (literally) for the electricity it would take to run your light bulb for one hour? Have you ever decided you’d rather carry your 50 lbs. of weekly groceries home for 5 miles rather than pay $1 for the gasoline it would take to drive? Of course not. The vast majority of energy-consumption decisions you make in life are no-brainers, because the cost is so little compared to the value you derive from saved labor and time.

This is an instance of a foundational but often neglected principle of economics: the market price of a good is determined by its marginal value—the value of the least valued use among all those uses actually made of it. For a man whose wife is in labor and needs to get to the emergency room, he might be willing to pay thousands of dollars in that moment for an extra gallon of gas, rather than birth the child himself. Another man driving his wife’s dog to the pet salon may only be willing to pay $3/gallon. The total demand for gas—the number of gallons that would be purchased—goes down as the price goes up.

Conversely, the supply of gas—how many gallons oil producers and refiners are willing to produce—goes up as the price goes up, because ever higher prices mean they could still turn a profit while employing less and less efficient (more and more costly) means of producing and refining extra amounts of it. The intersection between these supply and demand schedules—when the price is at just the point that producers are willing to produce the same quantity of the good that consumers demand—is what determines the actual market price. If that intersection happens to be right at $3/gallon for gas, it is the value of gas as used for the pet salon trip—the least urgent use—which is its marginal value, setting the market price.

Your grocery trip, on the other hand, is far from the least urgent use of that gasoline, and so you reap an overwhelming fraction of the gains-from-exchange occurring when you pay $1 for it. The oil company’s profit is something like 1 cent. You, however, would have paid, say, $50 rather than dramatically reduce your grocery load and walk home. That’s a 1 cent windfall for the oil company and a $49 dollar windfall for you. This brings to light a certain irony in claims about the exploitation of the $49-gainer by the callous oil tycoon who has gained 1 cent.

It also puts into context assertions about the “negative externalities” visited on, e.g., fisherman of streams subject to higher polution levels in the vicinity of oil refineries, or visited on horse-and-buggy makers left unemployed after the car and oil industries began to ramp up. There is a popular idea that these “hidden costs,” lumping together real violations of pre-existing property and mere changes in people’s demand for certain goods, need to be tabulated for all affected parties and used to penalize producers. But this idea is invoked almost universally while ignoring positive externalities like that $49 windfall.

Whatever can be made of the idea of aggregating the value derived by different individuals from a given good, the total dollar value paid for that good by these individuals is a woefully inadequate estimate of it. A proper estimate cannot ignore the unpaid-for benefits of the good just because they tend to be omnipresent in daily life and, therefore, taken for granted.

But the economist Ronald Coase has shown that such an estimate is beside the fact, even in purely economic terms. Coase’s theorem tells us what is the essential prerequisite for optimal resource usage, and it is not a (practically impossible) cost-benefit calculation. Rather the prerequisite is a precise definition of the property rights involved. This is because those harmed by someone else’s activity (e.g., oil refining) can bundle such rights as necessary to bargain with him, leading to satisfaction of the most urgent needs associated with all the raw materials (e.g., unrefined oil and fishing streams) in question.

What this means is that economists like Paul Krugman should not be cooking up ways to penalize producers for every conceivable negative impact of the technology that has lifted humanity from 35-year lives of unrelenting break-back labor to iPhones and 40-hour/week desk jobs. What is needed instead is just to maintain a stable system of pre-defined property rights to protect all individuals and to allow them to improve all their lots through mutually beneficial trade and long-range, entrepreneurial planning.