So how do we determine prices, anyway?

by William Grosso

I've been looking at buying a home recently. It's a good investment and interest rates are low. And I've always wanted to own my own place (and not be a renter).
There's a problem, though. I learned a fair amount of economic theory as an undergraduate. Mostly "classical" economics, plus a fair amount of highly technical pricing economics (things like the capital asset pricing model).

A lot of what I learned there doesn't seem to apply in the home market. Or, at least, it's not obvious how to apply it. Home prices are dependent on an extraordinary number of factors, and it's not clear that there's enough of a "market" (in the sense of lots of almost-fungible goods or enough readily available information), to figure out what the right price for a house should be.

And so, since I've got a virus and am home sick today, I decided to read a basic economics text and get a through grounding in the basic logic of markets.

It's a good book, but offers very little practical guidance for the home buyer (and, indeed, though this may be the virus speaking, Sowell sounds an awful lot like Dr. Pangloss at times).

Then I got even more confused. I gave up on thinking about houses and started thinking about software. Because all the pricing models I've ever learned about, including Sowell's exposition, assume that there's some fixed cost to producing the good, and some per-item (or marginal) cost.

And I've known for a long time that the per-item cost of software is pretty darn close to zero. But it never occured to me just how big a problem this is.

You see, Sowell devotes a huge amount of space to the argument that prices are signals. That is, every price is a indicator of the value of something. And the sum total of those indicators, those millions of individual signals, tells society how to allocate resources (though, there's no "society"-- it's just each individual actor, acting individually, that determines how to maximize his or her revenue). The net effect is that a price-driven economy is a very effective way allocate scarce resources to the items and areas that society, as a whole, finds most valuable.

It's sort of a moral argument for capitalism. And it makes a lot of sense when goods require resources to produce.

The question is: how does this work when the product is information? How well do markets and prices work when they're not adjudicating competing claims to scarce resources?

And when I say "how well do they work," what is it that they're doing, anyway?

Teach me some economics! But please, no flames.


2003-02-19 16:41:11
Post-Sowell economics
Sowell is a great writer and thinker, but his economics text reflects an era when the "neo-classical framework" ruled economics. That framework didn't suit products like software very well; it generally assumed that economies of scale didn't exist. People started to notice, too. In the mid-80s an economist called paul Romer began developing something called "endogenous growth theory", which among other things was devoted to modelling a world in which companies like Microsoft were common. This takes some tough maths (one reason why it wasn't done earlier). But endogenous growth theory has in the past ten years become part of the standard economics toolset.

Its repercussions will take a while to filter through into the general community, though.