Economics Puzzles (If You Don't Know Price Theory)

A lesson in the theory of demand

There is a story that I have heard from multiple people about Armen Alchian. A younger faculty member who was taking over teaching responsibilities approached Alchian and asked him what he generally taught. Alchian said, “I teach the theory of demand.” The other faculty member replied, “yes, I have a couple of weeks on that. What else do you teach?” Alchian purportedly answered, “I teach the theory of demand.”

I have no idea about the accuracy of the story, but I love the story, so I will continue to repeat it. The reason that I love this story is that it reveals a tendency in economics to get beyond the “simple stuff” as quickly as possible so that one can get to the “good stuff.” What is purported to be the “good stuff” is often more complicated. It is also generally motivated by some puzzle that cannot be explained by the “simple stuff.” Alchian repeating that he teaches the theory of demand has always struck me as an argument that the theory of demand is the good stuff and that it is anything but simple. Not only that, many of the supposed puzzles that require use of the “good stuff” can actually be understood with a deeper understanding of the “simple stuff.”

One such supposed puzzle about human behavior comes from what is known as the “ultimatum game.” Experimental economists use this game to examine a particular type of negotiating behavior. The game works as follows. The experimenter makes an amount of money available, say $10, and there are two participants in the experiment. The first participant makes an offer about how to split the $10 between each participant. The second participant can then accept the offer or decline the offer. If the offer is accepted, then the money is split as proposed by the first participant. If the offer is rejected, neither participant receives anything.

Given this basic setup, how would economic theory predict that people behave?

The standard argument relies on gains from trade. According to this argument, the first participant should offer the second participant $0.01 and keep the remaining $9.99. In terms of gains from trade, this is beneficial to both parties since the alternative is that they both get nothing. However, what you find when people actually play the ultimatum game is that they tend to split the $10 fairly even. In other words, the first participant is more likely to offer that each participant gets $5.

Critics of economic theory often suggest that results like this are puzzling. Why would it be the case that the first participant would share the $10 equally? Economic theory, we are told, should predict any positive amount offered by the first participant should be accepted. Don’t people understand gains from trade? Aren’t these people rational? More importantly, these critics argue that puzzles like this require us to rethink how we model economic decision-making.

But is that really what economic theory would predict?

Lester Telser argued that viewing this behavior as a puzzle misunderstands basic economics. What Telser argued is that people might actually value some measure of “fairness” just like they value any other commodity. As a result, the first participant is not only getting the $5, but also some level of satisfaction from having treated the other participant fairly.

Critics of economics, of course, are likely to scoff at this explanation. They would argue that this argument is tautological. They would say that Telser’s argument implies that if we can always just add another commodity to the utility function to resolve a puzzle, this would render economic models meaningless and devoid of predictive power.

Nonetheless, Telser took his argument one step further by pointing out that if the notion of fairness is a commodity just like any other, then the quantity demanded of fairness should be decreasing in its price. Perhaps people are willing to share the $10 evenly because $5 is a low price to pay to be fair. However, suppose that the cost of fairness was $10 or $100 or $5,000, as it would be if the money to be split was $20, $200, or $10,000, respectively. Would people continue to be fair (i.e. share the surplus equally)? The Law of Demand suggests not.

In principle, it would be possible to test this by conducting the experiment using dollar amounts progressively greater than $10. If Telser’s prediction is correct, then people would be less likely to share $1 million equally than they are the $10. Of course, testing this prediction would be hard. Testing the Law of Demand might require ever-higher values to split. I don’t know of anyone who has a research budget to run the ultimatum game with millions of dollars.

The fact that it would be hard to test Telser’s hypothesis with an experiment, however, does not preclude testing. Telser suggests using data for Major League Baseball players prior to the existence of free agency. During this period, owners held the rights to a particular player. The player could not negotiate with another team. The team that owned the rights to the player would therefore make an offer to a player. The player could accept the offer and play for the team. Alternatively, if the player rejected the offer, then they would not be able to play baseball.

While the actual details are a little more complicated than this, it is similar enough to the ultimatum game that one can test Telser’s hypothesis. For example, the baseball player produces a net marginal revenue product. The team makes the player a take-or-leave-it offer that is some fraction of the net marginal revenue product. The player can decide to accept the offer or walk away.

Telser plots the data on the net marginal revenue product produced by the players and the corresponding salaries of those players. What he finds is that as the net marginal revenue product of the player increased, the player’s salary increased. However, the salary increased at a decreasing rate. In other words, the greater the net marginal revenue product, the lower the share of that net marginal product the player received in terms of salary. Thus, the owners were willing to split the surplus more evenly when the surplus was smaller than when the surplus was larger. This is precisely what Telser’s hypothesis predicts. The higher the price of fairness, the lower the quantity demanded of fairness.

Telser’s hypothesis and his proposed test are important. While some claim that the ultimatum game implies that standard economic thinking might be missing something important, Telser teaches us that this seemingly puzzling behavior can actually be explained by the Law of Demand. Perhaps there is something to that Alchian story and we should spend more time on the theory of demand.