17.10.02

RESERVATION PRICES Volokh Conspiracy recommended Eric Cox's column on the Economics Nobel Prizes. Cox provides excerpts from an otherwise unattributed Los Angeles Times [Superintendent's note: embargoed account ridiculous registration screens] article that offers, "In a demonstration inspired by [Kahneman and his collaborator's] writings, University of Chicago economist Richard Thaler gave one group coffee mugs and a second group money, then offered to buy mugs from the first and sell mugs to the second. Classical theory would predict that students selling the mugs would ask for about the same price as the buyers would be willing to pay. But, in fact, the sellers asked for twice as much." Somehow, that doesn't surprise me. Sellers have lower reservation prices and gain by the receipt of any price above that price. We torture undergraduates with something called producer surplus, often obscuring the fundamental point. (If I've obscured the fundamental point here please advise.) Buyers have upper reservation prices and gain by paying any price below that price. Here the instrument of torture is called consumer surplus. Negotiation between a buyer and a seller leads to a (not necessarily unique) price that divides the consumer and producer surplus in some way. There's another instrument of torture called bilateral monopoly that I could pull out of my dunge^H^H^H^H^H kit here. Negotiation among multiple buyers and multiple sellers, with rapid discovery of the prices agreed to by others, leads to a single price that divides the consumer surplus and producer surplus among buyers and sellers in such a way that any further change in the price increases (decreases) consumer surplus by decreasing (increasing) producer surplus: thus, no mutually beneficial bargains remain.

And that's what U.S. News missed. Returning to Cox, "With regard to this experiment, the U.S. News story went so far as to claim that 'Adam Smith's invisible hand would have smacked the sellers over the head — classical economics says the right price is what people are willing to pay'." No, and Cox has it exactly right in his response. If the right institutions are in place, people will have incentives to do the right thing. Vernon Smith's experiments support the hypothesis that sufficiently informed traders, trading in competitive conditions, allocate resources efficiently. Take away the competitive conditions, under carefully controlled experimental protocols, and traders allocate resources as efficiently as they can, given the constraints. That line of research supports hypotheses that have been derived under the most rigorous of mathematical reasoning that economists can muster (and it's a sobering thought that almost all the central mathematical theorems economic theorists rely on come in the first chapter of a good text on real analysis.)

Something about the commentary on this year's Nobels recalls the Ronald Coase award a few years ago. Many observers took Coase's work to imply the superiority of market institutions over other forms of regulation. Not so. Coase argued that in the absence of transaction costs, assigning ownership of resources mattered less for purposes of resource allocation than dividing the gains from trade. The insight is in thinking about what is different if there are transaction costs, or if ownership of some things (the right to dock a ship, for example) is more easily established than other things (the right to observe a navigation beacon, i.e. a lighthouse). There's something similar in the Edward Lazarus quote that set off Juan Non-Volokh, "that human beings frequently do not act as the kind of supremely rational actors ordinarily posited in economic theory." I believe it was Harold Demsetz who once quipped that people would certainly use steel differently if they could get it costlessly, and why would information be any different?

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