The Utility of Prices

Okay so I'm back at Uni, and after what feels like months and months of not thinking about economics and finance at all, my brain is reengaging. Anyway this semester is actually looking pretty good subject wise. I only have one economics subject 'Pricing Theory' and it looks like it is taught 'well' by my definition unlike my Macro subject last semester which oversold its difficulty and employed too much coercion.

So Utility one of the central concepts of economics, it pretty much underpins all the decisions we make and all economic policies. Most often utility is taught as basically meaning 'happiness' which whilst I'm all for avoiding big technical language Orwell style I make an exception when lecturers simplify utility to 'satisfaction' or more painfully 'happiness'.

I'm fairly certain that they (John Stuart Mill and the classicists) employed utility because to suggest their models could explain or satisfy 'happiness' would be an outright lie. But similar to the behavioural management school - which manages behaviour because behaviour can be seen as opposed to 'attitude' which we can only infer.

Thus similarly I kind of assume that we use 'utility' because we can see people using shit, but can only infer whether it makes them happy.

So anyway, the past two weeks have been spent (not) drawing indifference curves. (I don't take notes in classes unless I absolutely can't avoid it) which are basically a two axis graph of X and Y (which can be anything) and a bunch of non intersecting curves that bow towards the origin. If you can't imagine it click this link.

And they kind of work well. Particularly when you add budget constraints, you get a nice neat world where people try to maximise their utility by maximising their consumption as far as their budget allows. Thusly thuserson you can even suggest that good X represents savings while good Y represents consumption and so forth.

People aspire to the 'highest' indifference curve. Are you following?

Now they've introduced three types of goods. A 'normal' good is a good that as your income increases or its price decreases you increase your consumption of it. Then you have 'inferior' goods which as your income increases you consume less of it (in favor of some substitute - eg. public transport, the richer you get the less you use it) then there are 'giffen' goods, these are goods that get cheaper but people consume less of them. They are treated as strictly hypothetical...

And this is where I always get interested in a lecture. The oddities, or when people see fit to introduce something that is only hypothetical - because this is perhaps my favorite half-baked theory of why economics is fucked yet.

See budget constraints, indifference curves and utility are all well and good if you keep utility and price away from eachother. But you get a quasi goedellien self-reference when you suggest that people derive utility from a price itself rather than the good it is affixed to. Hmmmmmmmmmmmmmmmmmmmahuhuh?

Imagine you got a pen right? right. You can use it to write right? right. So typically you would say the utility of a pen is its ability to write. But suppose you had a magic kind of pen that you could use or not use and it went up in price. All you had to do was hang onto it and it would go up in price. Now I guess we could call the appreciation of its price an indirect kind of utility, you can sell it and then use the proceeds to buy goods that have their own utility. This is kind of an opportunity cost or something, indeed money itself is worth only all the various things it can purchase if you want an on hand example.

But magic pens that go up in price regardless of how used don't exist right? wrong. This pretty much describes any speculative behaviour and it's corresponding wealth effect. Whether it is tulips, tech stocks or 'houses' speculation describes people deriving utility from price itself, rather than 'real' utility of the underlying asset. And these behave like giffen goods.

If people are consuming for price reasons, that is they buy a house anticipating further price rises and don't bother to live in it or rent it out (and worse, renovate it) then they are buying for the utility of the price and not the utility of the actual accomodation/location/infrastructure.

Now, this is another paradox I intend to deal with the 'risk averse' designation of consumers that inevitably drives them to risky speculative behaviour, but basically when people derive their utility, their pleasure through the 'wealth effect' which is the feeling one gets when sitting on an asset that is going up in price and then it drops in price - people consume less of it.

Which is all well and good, but whats exciting to me is the self-referential nature of goods that can impart utility from their price, or prices driving utility which makes it hard to ever fully explain consumer behaviour, rational prices etc.

Will ponder more... I need to get back onto Naive investor too.