Up to this point we have spent most of our time arguing that willingness to pay represents our best hope for guiding resources to their highest valued use. This might strike you as somewhat strange since our only concrete example of this approach--a bidding or auction market--would surely be a grossly impractical way to distribute the hundreds of millions of goods and services that must be allocated every day in a large economy. However, there is another way to distribute goods and services with which you are already very familiar. It incorporates the best features of the willingness to pay approach with a minimum of administrative maintenance. It is the organizing principle behind the allocation of resources in free market/capitalistic economies. It is currently on display at your local supermarket, laundromat, and music retailer. It is the price system. In this chapter we will begin to explain the connection between the price system and the willingness to pay approach.

We defined willingness to pay as the most you would be willing to spend to obtain a good. We also could have said that your willingness to pay for an item is the happiness, measured in dollars, that you expect to receive from the item. This definition may sound a bit strange to you, but it is really just a restatement of our previous definition, and you probably use it every day.

Each time you purchase (or do not purchase) a good, you compare your willingness to pay to its price. Say you eat a fine meal at the best restaurant in town. After eating broiled cod, crab legs, a T-bone steak, stuffed mushrooms, and a Caesar's salad, you find yourself a tad full. When the waiter brings around a tray of tempting desserts, you refuse. Though the French chocolate silk pie looks quite delicious, you decide that your $4.75 can be better spent elsewhere. NOTE: In this case, the price of the pie exceeds your willingness to pay. After dinner, you join your friends at the mall and purchase a new pair of designer jeans for $31 because your old pair suddenly was feeling a little bit tight. (You suspect they were shrunk in the dryer again.) NOTE: In this case, you decided that the $31 for the jeans could not be better spent elsewhere. Your willingness to pay exceeded the price of the jeans. We take this sentiment one step further by declaring that your willingness to pay for a good (the absolute most you would spend on it) is the happiness, measured in dollars, that you expect to receive from consuming it. At some price level, you would refuse to buy a pair of designer jeans. This price level is your willingness to pay, or the amount of happiness you expect to receive from your purchase.

Max, one of the authors, is no slave to fashion and would at most be willing to pay $30 for a pair of designer jeans. When Max goes to The Gap and discovers that jeans are $31 per pair, he decides that spending his money on other goods would be more pleasing, so he buys a pair of cheap slacks at Target. Bob, the other author, loves being a snappy dresser. He would be willing to pay up to $100 for the same jeans. At $31 a pair, he thinks that he is getting a great deal. From our previous work with willingness to pay, we know that Bob expects to receive more pleasure from the jeans than Max because he is willing to pay more. In fact, Bob expects to receive $100 in pleasure from a pair of designer jeans, while Max expects to receive only $30 in pleasure from them. Notice that even though Bob paid $31 for his jeans, he receives $100 in happiness (his willingness to pay) from them. Armed with this knowledge of willingness to pay, we can begin to draw an amazing insight.

Unfortunately, we cannot take credit for this amazing insight. It goes back at least as far as Adam Smith. It is the fundamental insight of economics, the foundational building block of the science of resource allocation. Here it is: PRICES CONTAIN INFORMATION ABOUT WHERE RESOURCES WILL PRODUCE THE GREATEST AMOUNT OF HAPPINESS IN SOCIETY. To understand this point is going to take a little bit of concentration on your part, but stick with it because this insight is worth working for. Here we go.

Let's suppose we have five consumers. Being the creative people that we are, let's call them Consumers A, B, C, D, and E, respectively. Let's also suppose that we have some "inside" information on each consumer. Literally. We are going to imagine that we could look deep into the heart and soul of each and know exactly how much that consumer would be willing to pay for one more T-shirt. Not how much the consumer thinks he will have to pay it. Not how much it's "worth" to them according to some nebulous standard of worth. When we say "willing to pay" we mean the maximum amount of their own money they would really be willing to give up in order to consume the good. If we think back to our auction example, each consumer's willingness to pay value represents the maximum amount they would be willing to bid in order to win that T-shirt in an auction. In other words, we are going to imagine that we know how much happiness--as measured by willingness to pay--an extra T-shirt would generate for each of our consumers.

Of course, in real life this information is known only by the consumer. Nobody can know just how much somebody else is willing to pay for something. But we are going to pretend we know this information in order to see something we otherwise would miss. The table below reports each consumer's personal willingness to pay value for the T-shirt.

 Suppose these five consumers each walked into a town where the going price of T-shirts was $10. At a price of $10, only two consumers would choose to buy T-shirts (Consumers B and C). Consumers B and C each anticipate receiving more than $10 of happiness from owning the T-shirt. Purchasing the T-shirt clearly makes them better off. The other three consumers would not choose to buy a T-shirt (Consumers A, D, and E). While they each would receive some happiness from the T-shirt, the amount of happiness they anticipate receiving is less than $10.

Let's stop for a moment to see if we really understand what's going on here. Answer the following one-question, multiple-choice exam.

The answer is not (a). While it is true that Consumer B paid $10 for the T-shirt, this only tells us that he anticipated receiving at least $10 of happiness from the T-shirt. Consumer C also paid $10 for the T-shirt. But his greater willingness to pay value indicates that he anticipated receiving greater happiness from the T-shirt than Consumer B.

How about answer (b)? In purchasing the T-shirt, Consumer B gained something from which he anticipated receiving $11.75 of happiness. In return, he gave up $10.00. Doesn't that trade make him better off by $1.75? Yes it does. But that's not the question. The question isn't how much better off Consumer B feels he is as a result of purchasing the T-shirt. The question is, how much happiness will Consumer B receive from owning the T-shirt. That's an important distinction. And one that is difficult to keep straight at times.

We will say this many times over in the course of this book: people get happiness from the consumption of goods and services, not from money itself. Money is merely the means that enables consumers to get goods and services. In evaluating the happiness that society receives from consuming goods and services, it is important that we remember to keep our eyes on the goods and services, and not the money. Forgetting this simple truth is the source of a great many economic fallacies, as we shall see later on.

So what's the answer to our question? The answer is (c), $11.75. The consumer's willingness to pay value tells us how much happiness he expects to receive from owning the particular good or service. With this firmly in mind, we can continue with our discussion of the "incredible information contained in prices."