On Economic Thought - 4

We spoke of the Neoclassical theory of prices being hit by the New Keynesians. But what exactly is this theory of price? A theory of prices and values is nothing more than an attempt to answer the questions - 'what is this good actually worth?', and 'why should it be worth that much?'. The analysis could be both descriptive (or as economists would like to call it, positive), or judgmental (normative).

When younger, I often wondered why SRK gets Rs. 2 crs for hamming through a steaming pile of rubbish like KKHH, while the guy who builds your house has no place to sleep once he is done building your house. Needless to say, these were just ponderings over the theory of prices and values. A belief that there is some 'true' value of a product or service is a very intuitive thought and is known as the intrinsic theory of value. In this case, the price of the good may be very different from its perceived value. This belief has a normative bias, for it asserts what a good should be worth, and thus lends itself very easily to adjectives like 'overpriced', 'too cheap', 'unjustified' and 'exploitative'.

On the other hand, the belief that a product or service is worth whatever its user is willing to pay for it is called the subjective theory of value. It thus converges the theory of value and the theory of prices into one. This idea is also known as utility theory and came to the forefront during the marginalist revolution, which is more or less the genesis of neoclassical economics as we know it today. It is somewhat unintuitive, and the fact that it can escape common intuition is one of the main reasons why people are often unwilling to place faith in the market system. It is also ostensibly descriptive in nature - it doesn't say what goods should be worth, just explains why they are priced the way they are.

Before the neoclassicals came along, there were, unsurprisingly, classical economists. I believe that there are three main strains of classical economics, i.e economics of the 18th and 19th centuries. The fountainheads of these strains are Adam Smith, David Ricardo and Karl Marx respectively. One could argue about this point forever, but let's accept the current categorisation as an easy rule of thumb. All three strains have similar, yet subtly different theories of value. They are similar in the sense that all three believed in the intrinsic theory of value. However, while Adam Smith proposed that the 'natural price' of a good is its cost of production, Marx asserted that the true value of a good should be the amount of labour that goes into producing it. Ricardo's ideas were somewhere in between, and he believed that while the labour theory of value is inherently wrong, it can serve as a good approximation. All three agreed, of course, on the fact that market prices can be widely different from this intrinsic value. However, while Smith believed that prices would tend to converge to the intrinsic value, Marx saw the difference between market prices and intrinsic values as another fault of the capitalist system.

Marx, of course, was uneasy with the importance of capital in the first place. But Smith was vindicated to an extent later when neoclassical economists showed that in a competitive market, prices should converge to the cost, albeit the marginal cost. Ricardo's ideas were resurrected later by Pierro Sraffa, but more on Sraffa and his followers later.

The neoclassical idea of the utility theory of value is an extremely powerful concept. However, I think that its claim of being descriptive and not judgmental is somewhat misplaced. If you make the ideas of price and value converge by asserting that a good is worth whatever its user is willing to pay, you are indulging in a tautology. The normative bias in this idea is the inbuilt implication that nothing is ever mispriced. The argument then becomes circular.

This is where the financial markets come in. Unlike, say a shirt, a stock is difficult to fall in love with. The idea of subjective values hardly makes sense when one talks of financial instruments. Thus, while the market price of a financial instrument is dependent upon the actual demand and supply, it is possible to arrive at a 'true intrinsic value' on the basis of a theoretically consistent system of valuation. This true value may differ, sometimes widely, from the market price and thus the financial markets provide a brilliant opportunity to test many of the assumptions and conclusions of neoclassical economics, including rationality and efficiency of markets and market participants. But more on the the financial markets later.