Tag Archives: price as relative measure of market value

Is the Price of Apples Determined by Supply and Demand for Bananas?

  • Imagine that we live in a barter economy. What determines the price of apples in banana terms? Does the price of apples, in banana terms, depend upon (a) supply and demand for apples or (b) supply and demand for bananas?
  • Price Determination Barter EconomyThe correct answer is (c), “both”. The price of apples, in banana terms, depends upon both supply and demand for apples and supply and demand for bananas. In this week’s post, we will explain why this is the case and we will outline a novel method for illustrating this phenomenon.
  • In last week’s post, “The Matrix of Prices in a Barter Economy”, we examined the theory that every price is a relative measurement of market value and explored the implications of this for price determination in a barter economy. In this week’s post, we will extend this concept and use a couple of simple examples to illustrate the principle that every price in a barter economy is a function of two sets of supply and demand.
  • Intuitively, the notion that the price of apples in banana terms depends upon supply and demand for both apples and bananas is not that difficult: the ratio of exchange “apples for bananas” must be determined by market forces for both of the goods being exchange. The real trick with this theory of price determination is illustrating the concept that every price is a function of two sets of supply and demand.
  • In order to illustrate the theory that every price is a function of two sets of supply and demand, we need to appreciate the difference between the relative measurement of a property and the absolute measurement of a property. More specifically, we need to introduce a “standard unit”, or “invariable” unit, of measurement for the property of market value. By adopting such a “standard unit” we can show, by example, how the price of one good, in terms of another, will react to changes in supply and/or demand for either of the goods.

Two Questions, One Answer

Let’s begin by contemplating two questions that relate to price determination in a barter economy.

Question One: What determines the price of apples, as measured in banana terms, in a barter economy?

At first glance, most students of economics will think that this is a very simple question. The vast majority of economics students would probably offer an answer along these lines: “The price of a good is determined by supply and demand for that good. Therefore, the price of apples is determined by supply and demand for apples.”

OK, let’s stick with that answer for a moment. Now, let’s ask our second question.

Question Two: What determines the price of bananas, as measured in apple terms, in a barter economy?

Once again, the most common answer to this question would be: “The price of a good is determined by supply and demand for that good. Therefore, the price of bananas is determined by supply and demand for bananas.”

At first sight, these might seem like reasonable answers to both of these questions. But if we dig a little deeper, we can see that a problem exists.

Let’s step back and think about the concept of “price”.

What exactly is the “price of apples in banana terms”? The price of apples in banana terms is merely a way of expressing the ratio of two quantities exchanged: a quantity of bananas for a quantity of apples. In essence, it is the number of bananas that must be exchanged for one apple in order for an exchange to occur in the current market environment. For example, the price of apples might be two bananas (if I want to buy an apple from you, I need to give you two bananas).

Now, let’s look at the other side of the picture. What is the “price of bananas in apple terms”? Once again, it is a ratio of exchange, “apples for bananas”. Indeed, it is exactly the same ratio of exchange but simply stated in different terms.

For example, if the price of apples is two bananas, then the price of bananas, in apple terms, is half an apple. Both described the same ratio of exchange: “two bananas for one apple” is exactly the same as saying “half an apple for one banana”.

In more technical terms, the price of apples in banana terms is simply the reciprocal of the price of bananas in apple terms. Both are merely different ways of stating the same “ratio of exchange” between apples and bananas.

Let’s return to the first question: “what determines the price of apples in banana terms?”

Is it correct to say that the price of apples, in banana terms, is determined solely by supply and demand for apples?

No. The market forces that determine the price of apples in banana terms must be the same as the set of market forces that determine the price of bananas in apple terms. Why? These two “different” prices are merely different ways of describing the same ratio of exchange.

So, how do we reconcile the notion that the price of apples, in banana terms, has something to with supply and demand for apples, while the price of bananas, in apple terms, has something to do with supply and demand for bananas?

There is a simple solution.

The price of apples in banana terms depends upon both supply and demand for apples and supply and demand for bananas. Similarly, the price of bananas in apple terms depends upon both supply and demand for bananas and supply and demand for apples.

In this way, the one ratio of exchange (apples for bananas) is determined by the same set of market forces (supply and demand for both goods). It doesn’t matter whether we state the ratio of exchange in apple terms or banana terms. The fact is that the ratio of exchange is determined by two sets of supply and demand: supply and demand for apples, and supply and demand for bananas.

Illustrating Supply and Demand in a Barter Economy

It is easier to understand the notion that price is determined by two sets of supply and demand if we illustrate the general concept and then perform a couple of simple examples. The general principle is illustrated in the slide below.

Example of Price Determination Barter Economy (1)

In simple terms, we can say:

  1. Supply and demand for apples determines the market value of apples;
  2. Supply and demand for bananas determines the market value of bananas;
  3. The price of apples, in banana terms, is the determined by the ratio of the two market values (the market value of apples divided by the market value of bananas);
  4. Therefore, the price of apples, in banana terms, is determined by both supply and demand for apples and supply and demand for bananas;
  5. [While it is not explicitly illustrated above, we can also say that the price of bananas, in apple terms, is determined by the ratio of the two market values (the market value of bananas divided by the market value of apples) and consequently by both supply and demand for apples and supply and demand for bananas.]

All else remaining equal, if the market value of apples V(A) rises, then the price of apples, in banana terms, will rise. Conversely, if the market value of bananas V(B) rises, the price of apples, in banana terms, will fall. (If bananas become more valuable, then you need fewer bananas to acquire the same number of apples).

This concept will become clearer as we explain it by use of example. But before we do, let’s quickly think about how it is possible to represent price as a function of two sets of supply and demand.

The key is the unit of measurement used on the y-axis. More specifically, the diagram above measures market value on the y-axis in “absolute terms”, that is to say, in terms of a “standard” or “invariable” unit of market value.

In nearly every supply and demand diagram, the y-axis unit of measurement is “price”. Price is a relative measure of market value: a price measures the market value of a primary good in terms of the market value of a measurement good.

If it is possible to measure a property on a relative basis, then it is also possible to the measure that same property on an absolute basis: if we can measure the property market value on a relative basis (as a “price”), then we can also measure the property of market value on an absolute basis.

What does it mean to measure something in the “absolute”?

This is a long subject that was addressed in detail in a recent post titled “The Measurement of Market Value: Absolute, Relative and Real”.

In simple terms, a measurement is considered to be “absolute” if we measure something compared to a “standard unit” of measurement. This begs the question, what is a “standard unit” of measurement?

In order for something to act as a standard unit of measurement it must possess two properties. First, it must possess the property that is being measured. Second, it must be invariable in the property that is being measured. (For example, “inches” are a standard unit for the measurement of length).

In the slide above, we assume that there is a “standard unit” for the measurement of market value. Once we have adopted this standard unit, we can illustrate supply and demand for apples in terms of this standard unit. As the market value of apples rises, the quantity of apples demanded falls and the quantity of apples supplied rises. The “equilibrium market value” of apples, V(A), is determined by the intersection of supply and demand for apples.

Similarly, on the right hand side of our slide, we can illustrate supply and demand for bananas in terms of this standard unit. As the market value of bananas rises, the quantity of bananas demand falls and the quantity of bananas supplied rises. The “equilibrium market value” of bananas, V(B), is determined by the intersection of supply and demand for bananas.

The Price of Apples in Banana Terms

Once we have illustrated supply and demand for both apples and bananas in terms of our standard unit for the measurement of market value, we can assemble a clearer picture regarding how the price of apples in banana terms is determined (or conversely, the price of bananas in apple terms).

We discussed the basic concept of “price” in a couple of recent posts, “The Matrix of Prices in a Barter Economy” and “A New Economic Theory of Price Determination”.

In essence, every “price” is nothing more than a relative measurement of market value. The price of one good (“the primary good”) in terms of another good (“the measurement good”) is determined by the market value of the primary good relative to the market value of the measurement good.

For example, suppose that I told you that one apple was twice as valuable as one banana. Question: what is the price of apples in terms of bananas?

If one apple is twice as valuable as one banana (in a “market value” sense), then someone must offer two bananas to purchase one apple. Therefore, the price of apples, in banana terms, is two bananas.

The price of the primary good (apples) in terms of the measurement good (bananas) is determined by the relative market value of the two goods. In this case, the market value of the primary good (apples) is twice that of the market value of the measurement good (bananas). Therefore, the price of the primary good (apples), in terms of the measurement good (bananas), is two units of the measurement good (bananas).

Mathematically, we can illustrate this as shown in the slide below. If we assume that V(A) is the market value of apples as measured in terms of our “standard unit” of market value, and V(B) is the market value of bananas as measured in terms of that same standard unit, then the price of apples in banana terms, P(AB), is merely the ratio of V(A) divided by V(B).

Price as Ratio of Two Market Values

Now, let’s return to our earlier supply and demand diagram. Supply and demand for apples determines the market value of apples. Supply and demand for bananas determines the market value of bananas. The price of apples, in banana terms, is simply the ratio of the market value of apples divided by the market value of bananas.

Example of Price Determination Barter Economy (1)

Two Simple Examples

The theory that every price is a function of two sets of supply and demand is more easily explained by way of example. In this final section, let’s consider two scenarios and the impact of each on the price of apples, in banana terms, in our barter economy

Scenario One: what happens to the price of apples, in banana terms, if there is an increase in demand for apples?

If there is an increase in the demand for apples, then the demand curve for apples moves to the right. The market value of apples rises from V(A)0 to V(A)1. Furthermore, the price of apples, in banana terms, rises. In simple terms, if apples become more valuable relative to bananas, then the price of apples, in terms of bananas, will rise. (It will require more bananas to purchase the same amount of apples).

Example of Price Determination Barter Economy (2)

In the slide above, supply and demand in the apple market is measured in terms of our standard unit (in terms of “units of economic value” or “EV terms”). However, we can illustrate the market for apples in both “standard unit” terms (in terms of the absolute market value of apples) and in “price” terms (in terms of the relative market value of apples). In this example, we can see that we end up with the same type of result, no matter what unit of measurement we use on the y-axis: the demand curve for apples moves to the right as measured in both absolute and relative market value terms.

Example of Price Determination Barter Economy (3)

So far, so good: but what happens if there is a change in the banana market? How does a change in the banana market impact the price of apples?

Scenario Two: what happens to the price of apples, in banana terms, if there is an increase in demand for bananas?

If there is an increase in the demand for bananas, then the demand curve for bananas moves to the right. The market value of bananas rises from V(B)0 to V(B)1. Bananas are, to put it simply, “more valuable”.

Example of Price Determination Barter Economy (4)

Now, what happens to the price of apples where the price of apples is expressed in banana terms?

If there is no change in market value of an apple, V(A) is constant, then the price of apples, in banana terms, must fall. In simple terms, if apples become less valuable relative to bananas, then the price of apples, in terms of bananas, will fall. (It will require fewer bananas to purchase the same amount of apples because bananas are now “more valuable”).

Traditional supply and demand analysis (with “price” on the y-axis) struggles with this scenario. If there is “no change” in the market for apples, then how is possible for the price of apples to fall?

The answer to this question is illustrated below. Although there is no change in the absolute market value of apples, the relative market value of apples falls (the market value of apples relative to the market value of bananas falls). If apple prices are expressed in banana terms, then a rise in the market value of bananas will have the effect of shifting down both the supply curve for apples and the demand curve for apples.

Example of Price Determination Barter Economy (5)

The fact is that while there has been “no change” in the market for apples when measured in terms of a “standard” or “invariable” unit of market value, there has been a significant change in the market for apples when measured in terms of bananas.

One Final Word

The view of The Money Enigma is that every price is a function of two sets of supply and demand. The model we have discussed above applies not only to the determination of barter prices (“good/good prices”), but also applies to the determination of money prices (“good/money prices”) and foreign exchange rates (“money/money prices”).

Consider this point. What happens if instead of using bananas to buy apples in the examples above, we use money. Should the principle be any different? The answer is “no”: a good theory of price determination should be able to describe the determination of any type of price.

The view of The Money Enigma is that supply and demand for money (the monetary base) determines the market value of money. In turn, the market value of money is the denominator of every money price in the economy. As the market value of money falls, all else remaining equal, the price level rise. This view sits in direct opposition to the traditional Keynesian view that supply and demand for money determines the interest rate.

Price Determined by Two Sets Supply and Demand

This theory is covered in more detail in the Price Determination section.

The Matrix of Prices in a Barter Economy

  • Prices existed before there was money. In the barter economy of our ancestors, there existed an entire matrix of different prices. For example, the price of corn could be expressed in many different ways (in terms of apples, in terms of bananas, in terms of rice etc.). Conversely, the price of other goods could be expressed in “corn terms” (for example, the price of apples could be expressed in terms of corn).
  • How was this vast array or matrix of prices determined? How were prices determined before money existed?
  • From a practical perspective, a discussion regarding how prices are determined in a barter economy may seem like a strange endeavor. After all, what could modern-day economic policy makers learn from understanding price determination in a barter economy? The answer is “a lot”.
  • Many commentators like to complain that there is something wrong with the fundamentals of modern economics, yet very few can clearly articulate exactly what is wrong and fewer still have any real idea regarding how one might fix the situation.
  • The view of The Money Enigma is that there is a problem and that we can trace that problem all the way back to microeconomic theory. More specifically, current microeconomic theories of price determination present a very “one-sided” view of the price determination process. It is this oversight more than any other that has led modern economics down the wrong path.
  • By examining how prices are determined in a barter economy, we can illustrate two important concepts regarding price determination. First, every price is nothing more than a relative measurement of the market value of the two items being exchanged. Second, every price is a function of not one, but two sets of supply and demand.
  • This week we will focus on the first point as it applies to the matrix of prices in a barter economy. Next week we will more fully explore the notion that every price is a function of two sets of supply and demand.

The Price of Corn in a Barter Economy

Let’s imagine that we live in a barter economy, an economy with no commonly accepted medium of exchange such as paper currency or gold coin. Now, what would you say to someone who asks you “what is the price of corn?”

In our modern, money-based economy this is an easy question to answer. Without thinking about it, we automatically express the price of corn in currency terms. For example, the price of one ear of corn might be three dollars, so we say “the price of corn is three dollars”.

But in a barter economy, we would have to clarify the question. After all, there isn’t one commonly accepted medium of exchange. So, when someone asks us “what is the price of corn?” we need to ask them “the price of corn in terms of what?”

For example, does this person want to know the price of corn in terms of apples, or the price of corn in terms of bananas?

In a barter economy there is a whole array or “matrix” of different prices. The price of any good can be expressed in terms of any other good. As economists, the question that should concern us is how is this matrix of prices determined?

For example, is the price of corn, in apple terms, determined by:

a). Supply and demand for corn; or

b). Supply and demand for apples; or

c). Both supply and demand for corn and supply and demand for apples?

Most students of economics will choose (a), the price of corn, in apple terms, is determined by supply and demand for corn. This response represents the very “one-sided” view of price determination that is taught today.

The correct answer is (c). The price of corn, in terms of apples, is determined by both supply and demand for corn and supply and demand for apples.

In order to understand why this is the case, we start with a simple idea: every price is a relative measurement of the market value of the two goods that are being exchanged.

This concept is best understood by way of example.

Question: In our barter economy, if one banana is twice as valuable as one apple and one ear of corn is twice as valuable as one banana, what is the price of corn in apple terms?

Answer: The price of corn, in apple terms, is four apples.

Let’s think through this. If the market value of a banana is twice that of an apple, then you would need to offer two apples to purchase one banana. In other words, the price of bananas, in apple terms, is two apples. Furthermore, if the market value of an ear of corn is twice that of a banana, then you would need to offer two bananas to purchase one ear of corn. Therefore, in order to purchase one ear of corn with apples, you would need to offer four apples.

In our simple example, we calculated three prices (the price of bananas in apple terms, the price of corn in banana terms and the price of corn in apple terms). In each case, the price of one good (the primary good) in terms of another good (the measurement good) is determined by the market value of the primary good relative to the market value of the measurement good. If the market value of the primary good is twice that of the measurement good, then you must offer two units of the measurement good in order to purchase on unit of the primary good.

The Matrix of Prices and the Measurement of Market Value

We can further illustrate this principle by creating a matrix of prices for our barter economy. In the slide below, the four goods in the economy (apples, bananas, corn and rice) are listed on the top row and first column. In the light shaded area you can see the price of each good in the top row in terms of each good in the first column. For example, the price of corn in terms of apples is four apples.

Matrix of Prices in a Barter Economy (Slide 1)

What this slide attempts to highlight is the basic principle that price is a relative measurement of market value. For example, if the market value of a banana is twice the market value of a cup of rice, then the price of bananas in rice terms is two cups of rice. Every one of the prices in the light shaded area is a relative measurement of the market value of one good (a good in the top row) in terms of the market value of another good (a good in the first column).

Moreover, if we can measure market value in relative terms, then we should also be able to measure market value in absolute terms. But what does it mean to measure a property in absolute terms?

We discussed this at length in a recent post titled “The Measurement of Market Value: Absolute, Relative and Real”. In simple terms, in order to measure a property in absolute terms, we need a “standard unit” for the measurement of that property. A “standard unit” is invariable in the property that it is used to measure (for example, inches are an invariable measure of the property of length).

In the slide above, we have arbitrarily assigned a market value of five standard units to one apple. If a banana is twice as valuable as an apple, then the market value of a banana, as measured in terms of our standard unit, is ten. These “absolute” market values are written next to the names of the various goods in our economy.

Now we can use this matrix to examine what happens if there is a change in the market value of one of the goods in our barter economy.

For example, what happens to prices in our barter economy if the market value of corn falls by 50%?

Stated in more formal terms, what happens to the matrix of prices in our barter economy if the market value of corn, as measured in terms of our standard unit, falls by 50%, assuming that the market value of all other goods, as measured in terms of the standard unit, remain constant?

The fall in the market value of corn has two repercussions on the matrix of prices: the first is obvious, but the second is not.

The first impact is on the price of corn as measured in terms of any other good in the economy. Clearly, if the market value of corn falls, while the market value of another good remains constant, then the price of corn in terms of that second good will fall. The red column in the table below highlights how the price of corn, as measured in terms of other goods, falls.

Matrix of Prices in a Barter Economy (Slide 2)

Whereas previously the price of corn in apple terms was four apples, the price of corn in apple terms is now only two apples.

The second impact on the matrix of prices is less obvious. If the market value of corn falls, then the price of every other good, as measured in corn terms, will rise. You can see this highlighted in the blue row in the table below.

Matrix of Prices in a Barter Economy (Slide 3)

The price of a banana, in corn terms, rises from half an ear of corn to one whole ear of corn. Why does this happen? There has been no change in the market value of bananas, as measured in terms of our “standard unit”, but the price of bananas rises. The reason is because price is a relative measure of market value. In this case, the price of bananas, in corn terms, reflects both the market value of bananas and the market value of corn. If the market value of corn falls, then the market value of bananas rises.

This can be stated in mathematical terms as follows. If the market value of good A in terms of our “standard unit” is denoted as V(A), and the market value of good B in terms of our “standard unit” is denoted as V(B), then the price of good A, in terms of good B, denoted as P(AB), is the ratio of V(A) divided by V(B).

Price as Ratio of Two Market Values

The price of good A, in terms of good B, can rise either because (1) the market value of good A rises, or (2) the market value of good B falls.

We can take this one step further. If the market value of good A is determined by supply and demand for good A, and the market value of good B is determined by supply and demand for good B, then the price of A, in B terms, is determined by both supply and demand for good A and supply and demand for good B.

Price Determination Theory

We will explore this concept next week and apply it to a couple of examples of price determination in a barter economy. But before we do, it is worth asking what any of this has to do with the determination of prices in a money-based economy?

The view of The Money Enigma is that the model of price determination just described is a universal model of price determination. It is universal in the sense that it is a theory that describes how any price is determined, including a “money price” (the price of a good in money terms).

In simple terms, the price of a good, in money terms, is a relative expression of both the market value of the good itself and the market value of money. If the market value of money falls, the price of the good, in money terms, will rise. In this sense, the market value of money is the denominator of every money price in the economy. Moreover, supply and demand for money (the monetary base) determines the market value of money, not the interest rate.

This simple notion, if correct, represents a direct challenge to existing economic thinking. If you would like to explore this concept in more detail, then you should read The Inflation Enigma, the second paper in The Enigma Series. For a shorter summary, you can a recent post titled “A New Economic Theory of Price Determination”.

A New Economic Theory of Price Determination

  • The view of The Money Enigma is that current microeconomic models of price determination provide a limited and very one-sided view of the price determination process. In this week’s post, we shall explore the theory that every price is a function of two sets of supply and demand. More specifically, the price of one good (“the primary good”) in terms of another good (“the measurement good”), is determined by both supply and demand for the primary good and supply and demand for the measurement good.
  • The traditional microeconomic view is that price is determined by supply and demand for one of the goods being exchanged (the “primary good”). For example, the traditional view is that the price of apples is determined by supply and demand for apples. However, in every transaction, there are two goods that are exchanged.
  • For example, in a barter economy, we might exchange two bananas for one apple. So, does the price of this trade (the ratio of bananas for apples) depend upon supply and demand for apples or supply and demand for bananas? The answer is both.
  • We can apply this concept to the determination of “money prices”. In a money-based transaction, we exchange one good (the primary good) for money (the measurement good). The price of the primary good, in money terms, is a function of both supply and demand for the primary good and supply and demand for money (the measurement good).
  • The notion that “every price is a function of two sets of supply and demand” provides us with a universal theory of price determination: it is a theory of price determination that can be applied to the determination of any price: good/good prices (barter prices), good/money prices (“money prices”) or money/money prices (foreign exchange rates).
  • In order to illustrate every price as a function of two sets of supply and demand, we need to understand the measurement of “market value”. In last week’s post, we examined what a “price” is. It was argued that every price is a relative measurement of market value: the market value of one good (the “primary good”) in terms of the market value of another good (the “measurement good”).
  • Furthermore, we discussed the notion that market value can be measured in the absolute. In order to measure a property in the absolute, you need a “standard unit” of measurement. It was proposed that economics should adopt a standard unit for the measurement of market value called “units of economic value”.
  • We can use this standard unit to plot how supply and/or demand for a good might react to changes in the absolute market value of that good (the market value of the good as measured in terms of our “standard unit”). Rather than plotting supply and demand with price (a relative measure of market value) on the y-axis, we can plot supply and demand using our “standard unit” on the y-axis (an absolute measure of market value).
  • Importantly, this allows us to plot supply and demand for both goods that are being exchanged independently. We can then examine whether a change in the price of the primary good, in terms of the measurement good, is due to a change in supply and demand for the primary good or supply and demand for the measurement good.

Price Determination TheoryThe view of The Money Enigma is that every price is a function of two sets of supply and demand.

What this means, in simple terms, is that the price of one good, in terms of another good, depends upon supply and demand for both goods.

Price Determined by Two Sets Supply and DemandFurthermore, this principle holds true in a money-based economy. The price of a good, in terms of money, depends upon both supply and demand for the good and supply and demand for money (the monetary base). Notably, supply and demand for money (the monetary base) determines the market value of money, not the interest rate.

There are two ways to explain this theory. First, there is a simple, intuitively appealing and fairly non-technical way to think about the issue. Second, there is a far more technical path that requires an understanding of the issues discussed in last week’s post “The Measurement of Market Value: Absolute, Relative and Real”. Let’s begin with a simple overview of the theory and think about how prices are determined in a barter economy.

Price Determination in a Barter Economy: A Simple Overview

Price determination in a barter economy may seem like a strange topic to discuss in a world where nearly all transactions are conducted with money. However, analysing the process of price determination in a barter economy allows us to get back to basics and really think about the issues involved.

If we can understand how prices are determined in a barter economy, then this provides us with a basic model that we should be able to extend into a money-based economy. Furthermore, a comprehensive theory of price determination should be able to explain not only the determination of prices in a money-based economy, but also the determination of prices in a barter economy with no money and no accepted medium of exchange.

Let’s imagine a barter economy with no accepted medium of exchange (no good is used as “money”) and think about how prices are determined in that economy. For example, let’s try and answer this question: “how is the price of apples determined in a barter economy?”

Already, we have a problem. What do we mean when we say “the price of apples” in the context of a barter economy?

In a money-based economy, we would normally assume that the question refers to the price of apples in money terms. However, in our barter economy, there is no money and no good that is used as money. So, exactly what is “the price of apples” in the context of a barter economy?

There are many different ways to express the price of apples in a barter economy. We could express the price of apples in terms of bananas, or in terms of rice, or in terms of any other good that is widely traded in that economy.

The key point here is that the price of apples must be expressed in terms of some other good. Why? Every price, including the “price of apples”, is a ratio of two quantities exchanged: a certain quantity of one good for a certain quantity of another.

Let’s choose bananas as our second measurement good, the good that we use to measure the price of apples and let’s ask the question again: “how is the price of apples, in banana terms, determined in a barter economy”?

Now we have a meaningful question to answer. But before we do, let’s restate the question. As discussed, every price is a merely a ratio of two quantities exchanged. So let’s rephrase the question this way: “how is the ratio of exchange between bananas and apples determined in a barter economy?”

Does the ratio of exchange, “bananas for apples”, depend upon supply and demand for apples, or does it depend upon supply and demand for bananas? The answer is both.

For argument’s sake, let’s assume that the current ratio of exchange in our barter economy is two bananas for one apple (the price of apples, in banana terms, is two bananas). What are the factors that might influence this ratio of exchange?

What would be the impact of a sharp reduction in supply of apples upon the ratio of exchange? For example, if the apple crop failed and apples were in short supply, then, all else remaining equal, what would happen to the ratio of exchange “bananas for apples”? Clearly, the price of apples, in banana terms would rise: you would have to offer more than two bananas in order to get your hands on an apple, apples now being in short supply.

This example sits well with mainstream theory. A reduction in the supply of apples will increase the price of apples.

Now, let’s try a different scenario. Once again, let’s assume the ratio of exchange is two bananas for one apple. What happens if, all else remaining equal, there is a sharp reduction in the supply of bananas?

Let’s step back and think about this. Imagine a new parasite damages most of the banana tress and the supply of bananas is cut dramatically. All else remaining equal, do you think it would still be possible to swap one apple for two bananas? No. There is a shortage of bananas and bananas are now more valuable. Therefore, you would expect that one apple might only be able to obtain one banana, rather than the previous two bananas. Perhaps you might even need to offer two apples to buy one banana.

The point is that our ratio of exchange, bananas for apples, depends upon both supply and demand for apples and supply and demand for bananas. The problem for mainstream economics is that our example implies that the price of apples (the ratio of bananas exchanged for apples) depends upon supply and demand for bananas!

So, how do we resolve this seemingly awkward situation?

At a high level, the answer is simple. All we need to do is to recognize the general principle that the price of one good, the “primary good”, in terms of another good, the “measurement good”, depends upon both supply and demand for the primary good and supply and demand for the measurement good.

In the case of our example, the price of apples (the “primary good”), in terms of bananas (the “measurement good”), depends upon both supply and demand for apples and supply and demand for bananas.

The harder issue that we need to address is how do we illustrate this? How do we show the price of apples, in banana terms, as a function of two sets of supply and demand?

This brings us to the more technical part of our discussion. In order to understand how every price can be illustrated as a function of two sets of supply and demand we need a better understanding of what a “price” is and how the property of “market value” can be measured.

Every Price is a Function of Two Sets of Supply and Demand

In order to understand how every price is a function of two sets of supply and demand, we need to step back and think about the concept of “price”.

So far, we have discussed the widely accepted notion that every price is a ratio of two quantities of exchanged: a certain quantity of a measurement good for a certain quantity of a primary good.

This definition is fine, but it doesn’t tell us much about the process of price determination. Rather, we need to think about the concept of “price” in more fundamental terms. More specifically, what does the price of a good, in terms of another good, indicate to us about the relative economic relationship that exists between the two goods?

Let’s return to our apples and bananas example for one moment. If the ratio of exchange in our barter economy is two bananas for one apple, then what does that imply about the value of apples relative to the market value of bananas? Clearly, it suggests that one apple is worth twice as much as one banana.

In slightly more technical terms, we can say that the market value of one apple is twice the market value of one banana. The apple possesses the property of “market value”. Similarly, the banana possesses the property of “market value”. The price of apples, in banana terms, reflects the relative market value of the two goods being exchanged (the market value of apples relative to the market value of bananas).

Therefore, we can say that “price” is a relative measurement of the property of “market value”. All economic goods (including money) possess the property of market value. A “price” is one method of measuring the market value of a good: it measures the market value of a good in terms of the market value of another good. For example, if the price of an apple, in banana terms, is two bananas, then this implies that an apple has twice the market value of a banana.

The observation that “every price is a relative measure of market value” is interesting because it suggests that there is an alternative way to measure the property of “market value”: the alternative method is measuring market value in the absolute.

Before we think about measuring market value in the absolute, let’s think about what is required to measure any physical property in the “absolute”. We discussed this topic at great length in last week’s post “The Measurement of Market Value: Absolute, Relative and Real”. While the topic may seem a little abstract, it is a critical concept to this theory of price determination and I strongly encourage you to read it.

By convention, in order for a measurement to be considered an absolute measurement, it must be made using a “standard unit” of measurement. For example, in order to measure the height of a tree in an absolute sense, we need a standard unit of measurement for height, such as inches.

Standard units of measurement have two critical properties. First, they must possess the property that they are used to measure. Second, they must be invariable in that property.

There is a third property common to most standard units: they tend to be theoretical in nature. For example, there is no such thing in nature as “one inch”. We made it up. The reason most standard units are artificial/theoretical is because almost nothing in nature is invariable.

This is true of the market value of goods. No good possesses the quality of invariable market value. Therefore, no good can act as a “standard unit” for the measure of market value. This is also true of money (currencies). No currency possesses the property of invariable market value.

So, how do we measure market value in the absolute? We need to create a standard unit for the measure of market value. Since no standard unit for the measurement of market value exists in nature, we need to make one up. In last week’s post, I proposed that we introduce a standard unit called a “unit of economic value”. “Units of economic value” are invariable measures of the property of market value, just as feet and inches are invariable measures of the property of length.

Adopting this standard unit for the measurement of market value is important because it allows us to demonstrate two critical points.

First, it allows us to illustrate how the price of a primary good, in terms of a measurement good, is a relative expression of the market value of both the primary good and the measurement good.

Consider our earlier example, the price of apples in banana terms. Let’s assume that we measure the market value of apples using our new standard unit. We can now measure the market value of apples in the absolute and denote this as V(A). Furthermore, we can separately measure the market value of bananas using our new standard unit and denote the absolute market value of bananas as V(B).

Price as Ratio of Two Market ValuesThe price of apples, in banana terms, is a relative measurement of the market value of apples V(A) and in terms of the market value of bananas V(B). For example, if the market value of an apple is twice that of a banana, then the price of apples, in banana terms, is two bananas. Mathematically, the ratio of quantities exchange, the quantity of bananas Q(B) for a quantity of apples Q(A), is simply the reciprocal of the ratio of the two absolute market values.

The slide above implies that the price of apples, in banana terms, simply depends upon the market value of apples relative to the market value of bananas. All else remaining equal, if the market value of apples V(A) rises, then the price of apples will rise. Conversely, if the market value of bananas V(B) rises, then the price of apples, in banana terms, will fall.

We can extend this to a money-based economy. In a money-based economy, the market value of money is the denominator of every “money price”. All else equal, if the market value of money rises, then prices will fall. If the market value of money falls, then, all else equal, prices will rise.

The second important use for our standard unit for the measurement of market value is that it allows us to demonstrate how every price can be illustrated as a function of two sets of supply and demand.

As discussed, the price of apples, in banana terms, depends upon both the market value of apples V(A) and the market value of bananas V(B). How is the market value of a good determined? Supply and demand!

Price Determination Barter EconomyThe market value of apples V(A) is determined by supply and demand for apples. The market value of bananas V(B) is determined by supply and demand for bananas. The price of apples, in banana terms, is a relative expression or a ratio of these two market values. Therefore, the price of apples, in banana terms, is determined by two sets of supply and demand.

This illustration of the price determination process is  useful because it allows us to isolate and analyze how changes in either market (the market for apples or the market for bananas) may impact the price of apples as measured in banana terms. For example, an increase in supply of bananas will lower the market value of bananas V(B). If nothing changes in the market for apples (the market value of apples V(A) is constant), then the price of apples, in banana terms, will rise as a result of an increase in supply of bananas.

Price Determined by Two Sets Supply and DemandWe can extend this paradigm to the determination of money prices by simply replacing one measurement good (bananas) with another measurement good (money). The price of apples, in money terms, is determined by both supply and demand for apples and supply and demand for money.

It should be noted that this concept sits in stark contrast to traditional Keynesian theory. Keynes’ liquidity preference theory suggests that supply and demand for money determines the interest rate. The view of The Money Enigma is that this is wrong. In order for prices to be expressed in money terms, money must possess the property of market value. Supply and demand for money determines the market value of money. In turn, the market value of money is the denominator of every “money price” in the economy.

Before we finish this week’s post, I want to make one final point. This theory of price determination can be neatly reconciled with the traditional illustration of supply and demand taught in economics textbooks.

The traditional view is that the price of a good is determined by supply and demand for that good. Economists illustrate this by using “price” on the y-axis. This view of the price determination process is fine as long as it is recognized by the user that this traditional illustration of the price determination process implicitly assumes that the market value of the measurement good is constant.

For example, in our barter economy, if we assume that the market value of bananas is constant, then when we plot supply and demand for apples we don’t need to use our theoretical standard unit for the measurement of market value on the y-axis. Rather than using a theoretical invariable measure of market value (units of economic value) we can simply use an assumed invariable measure of market value (the market value of bananas).

While it may not be explicitly acknowledged, most textbook illustrations of price determination simply assume that the market value of the measurement good (most commonly “money”) is constant. This is perfectly fine if the assumption is acknowledged. However, this traditional view of supply and demand provides most students with a very one-sided view of the price determination process.

The view of The Money Enigma is that every price is a function of two sets of supply and demand. The current mainstream view that price is a function of one set of supply and demand is a primary source of many misconceptions in economics, most notably, the poorly conceived notion that supply and demand for money determines the interest rate.

If you would like to learn more about these theories then please visit the Price Determination section of The Money Enigma.

Author: Gervaise Heddle, heddle@bletchleyeconomics.com