An Economics of Single Transactions

I recently read Thomas Sowell's Classical Economics Reconsidered and it struck me that the classical treatment of supply and demand is not adequate when dealing with the real world of price, value, and cost. Consumers don't face a large market of many suppliers. For a real consumer there are many constraints on geography, time, and resources that nearly completely block any kind of decision-making in what might resemble the supply and demand curves of classical microeconomics. 

I'd written on a framework that I put together in 1993 and 1994 that I called "nanoeconomics" ("nano"). I presented a paper on it at a Department of Defense cost analysis symposium in 1994. At the time I was still in need of reading more of the literature, so after working out the basic influences that can be captured in a single transaction framework, I set it aside. I published a blog post in 2011 outlining the basic ideas. Now that I had Sowell's overview in hand, it was clear that the nano framework was not only useful but necessary for understanding decisions in real marketplaces.

If you look back 1000, 2000, or 300 years, or pick almost any point in human history, you will find that humans have traded goods and done so rather enthusiastically. Marketplaces exist because all participants profit from the transaction. However, ever since the dawn of the Industrial Age the rapid growth in production and resources has changed the complexion of the marketplace. It has induced some like Marx and his followers to attempt a reformulation of basic economics, to declare that "cost equals value" or that labor cost equals value. It seems rather drastic to discard the entirety of market economics just because of bruised feelings. The nano framework is necessary to provide a foundational vocabulary and to put the questions of transactions into a robust framework. 

The basic problem is determining a price for a transaction. Note that we've already assumed a medium of exchange (money) in which we can measure costs, marginal utility (opportunity cost), and of course, price. As indicated in the diagram, producer costs must be below the consumer's private value of the good or the net effect of the transaction is to destroy net societal resources. 

Clearly both sides must be motivated to make the trade, or no trade is likely to occur. This is resolved by splitting the profit. In a modern, competitive economy or in a robust town market there will be multiple suppliers. Although the consumer has an "ultimate" value which is the cost of doing without any transaction, the consumer's negotiating value is the price of the next-best deal, or the price of the next higher offer.

The situation is slightly different for unique goods, or those offered by a monopolist or bought by a monopsonist. Now the supplier and customer must exchange information and negotiate, at first just to discover that a trade is possible, then to explore possible trading prices. Often the customer has the information advantage, because their ultimate value is what sets the limit on price and profit, and this ultimate value is usually private information that is costly for the seller to discover (at least until Google and Internet ad tracking systems made it possible to read the minds of internet users): 

One might argue that splitting such profits is "fair" if the price establishes a geometric ratio such that each party's gain is proportional with the same factor. In such cases, consumers still make bigger profits on an absolute basis.

The nano framework gives some rather precise definitions of words that are frequently confused or problematic in debates of classical economics. Cost is the suppliers costs; often this will be private information, except for most government contracting. Value is usually private to the consumer, but since it is subject to rapid change, the consumer may not be fully informed themselves. Consumers have strategies for protecting themselves from this variability, and these mechanisms also contribute to the "buffer" often required by a consumer that tends to increase average realized consumer profit. 

But isn't this just like classical microeconomics? Isn't the single transaction "thermometer" diagram a slice out of the supply and demand diagram?

It turns that it is not. One must make some very large and unusual assumptions to establish a supply/demand analysis. In the real world, consumers very rarely face such efficient markets.

In the real world, people walk through a continually moving "bubble" of opportunity costs. Movement between prospective transactions is costly. If you are at a local corner grocery store, you cannot immediately reach out and take advantage of prices at Costco or a supermarket. Comparison of prices itself involves effort, at finding prices on items, remembering them from elsewhere, and comparing sizes and quality and unit prices. In short, although the supply and demand curve graphic represents the general conceptual landscape faced by the consumer, in practice the demand curve is constantly changing in shape and magnitude, shifting back and forth in response to changes of location, competition for attention, and the immediacy of basic needs.

To fully understand what drives "ultimate" value, we would need to analyze the dynamics of decision-making within the consumer. Some have called this "neuroeconomics", others might put it under the label of behavioral economics.

It's useful to have some background on philosophy of ethics and morals. Goals for comfort, survival, and reproduction come into play. The most fundamental influences are very practical, involving food, water, temperature regulation, social interaction. Although clearly this will invoke most of the human sciences (psychology, anthropology, sociology, cultural evolution) we are getting closer. We at least know now whether the boundaries are, and that certain economic questions can be resolved very directly into organism-level analysis. Furthermore, we have some sense that actual market data, such as the price of a hot dog at a market, supermarket, convenience store, convention, and in the middle of a desert will all be useful in calibrating numerically the effects of organism-level goals and drives.