Tag Archives: price determination barter economy

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?

The 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.

In simple terms, we can say:

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 the determined by the ratio of the two market values (the market value of apples divided by the market value of bananas);
Therefore, the price of apples, in banana terms, is determined by both supply and demand for apples and supply and demand for bananas;
[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(A_B), is merely the ratio of V(A) divided by V(B).

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.

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).

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.

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”.

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.

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.

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.

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.

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.

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(A_B), is the ratio of V(A) divided by V(B).

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.

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.

The 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.

Furthermore, 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).

The 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!

The 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.

We 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

The Measurement of Market Value: Absolute, Relative and Real

In any scientific pursuit, it is critical to understand the different approaches that can be used to measure the physical properties that are being studied. At the most basic level, every scientist must be able to distinguish between an “absolute” measurement and a “relative” measurement.

Relative measurement is measuring something compared to other things, or estimating things proportionally to each other. For example, “the tree is twice as tall as the girl”.

Absolute measurement is measuring something compared to a “standard unit”. For example, we can use feet and inches to measure the height of the tree, “the tree is six feet high”.

What makes something a “standard unit” of measurement? A “standard unit” of measurement must possess two characteristics. First, the standard unit must possess the property being measured. Second, the standard unit must be invariable in that property (the length of one “inch” never changes; it is and must be invariable in order for it to be useful as a standard unit of measurement).

In the science of economics, one of the most important properties that economists are concerned with is the property of “market value”. Surprisingly, economics does not have a “standard unit” for the measurement of market value and, consequently, economics does not measure market value in the absolute.

“Price”, the most commonly used measure of market value, is a relative measure of market value. The price of one good, in terms of another good, is a relative measurement of market value, namely, the market value of one good (the “primary good”) in terms of the market value of another (the “measurement good”).

It is proposed that economics needs to introduce a standard unit for the measurement of market value. The adoption of this standard unit has many advantages. First, it can be used to illustrate how price is a relative expression of the market value of each of the two goods involved in an exchange. Second, it can be used to illustrate how every price is a function of not one, but two sets of supply and demand.

Furthermore, we can use the standard unit of market value to illustrate that supply and demand for money does not determine the interest rate. Rather, supply and demand for money determines the market value of money, the denominator of every “money price”.

In the last section, we will discuss the concept of “real prices”. Many commentators seem to believe that the “real price” of a good is somehow an absolute measurement of market value. It is not. It will be argued that a real price is a relative measure of market value. More specifically, the real price of a good is merely the market value of a good in terms of the market value of the basket of goods. The market value of the basket of goods is not invariable. Therefore, a real price is not an absolute measurement of market value.

Absolute versus Relative Measurement: the General Principle

The act of measurement is, by definition, an act of comparison. In this sense, all measurements are “relative”. For example, consider the height of the tree. We can measure the height of the tree in terms of the girl standing next to the tree (the tree is twice as tall as the girl) or in terms of feet and inches (the tree is six feet tall). Either way, we are comparing one thing that possesses the property of height/length (the tree) with another thing that possesses the property of height/length.

But if all measurement is an act of comparison (for example, comparing the tree to feet and inches), then what does it mean to say that a measurement is “absolute”?

A measurement is considered to be “absolute” if we measure something compared to a “standard unit” of measurement. In our example above, a “girl” is not a standard unit of measurement for the property of height/length. However, “feet” and “inches” are recognized as a standard unit of measurement for height/length. Therefore, the height of the tree in feet/inches is an absolute measurement of the height of the tree.

What makes something a “standard unit” of measurement?

In order for something to act as a standard unit of measurement for a given property, there are two key characteristics that thing must possess. First, it must possess that property. This may sound odd, but think about it. You couldn’t use an “inch” to measure length if an “inch” had no length.

Second, for something to be used as a standard unit of measurement, it must be invariable in that property. Measuring things in terms of “inches” wouldn’t be of much value to us if the length of one inch was constantly changing.

These are the two key characteristics of a standard unit of measurement, but there is a third characteristic that most standard units possess.: most “standard units” of measurement are theoretical.

In our example above, the girl has a certain physical height that exists in nature. However, the length of one “inch” is not something that exists in nature. We made it up. We decided, on a fairly arbitrary basis, that the length of one inch is “about that much”.

This is true of most standard units of measure: one hour, one mile, one kilogram – they are all theoretical measures of a particular property that we made up to help us measure various physical properties.

Why are most standard units of measurement theoretical? The reason we use theoretical entities as standard units of measure is because nearly everything in nature is variable. By definition, we can’t use objects that are variable in a property as “standard units” of measure of that property.

In summary, the key difference between an “absolute” and a “relative” measurement is the unit of measure being used. In the case of an absolute measurement, we use a “standard unit” of measure. Most standard units are theoretical units of measure and, importantly, they must be invariable in the property that they are measuring.

In contrast, a relative measurement is merely a comparison of one object (the primary object) with another (the measurement object): it does not require that the second object (the measurement object) is invariable in the property being measured.

In the next section, we will examine how “price” is a relative measurement of the property of “market value”. Furthermore, we will discuss the difference between “absolute” and “relative” market value and why the science of economics should introduce of a “standard unit” of measurement for the property of market value.

The Measurement of “Market Value”

By far the most popular way to measure the market value of a good is the “price” of a good. More specifically, the price of a good, as measured in currency terms, is what most people think of as the “market value” of that good.

However, “price” and “market value” are not the same thing.

“Market value” is a property of a good, a property determined by the interaction of economic agents. “Market value” is a property of a good, just as “length” is a property of a physical object.

“Price” is a method of measuring market value. More specifically, every price is a relative measurement: it is a measure of the market value of one good (the primary good) in terms of the market value of another good (the measurement good).

In our modern economy, the measurement good we normally use is money (prices are expressed in money terms). The problem with this, from a theoretical perspective, is that money is not a “standard unit” in the scientific sense. Why? Money is not a standard unit because the market value of money is not invariable. Rather, the market value of money, particularly fiat currency, is highly variable, especially over long periods of time.

Therefore, a “price” is a relative measure of market value, not an “absolute” measure of market value. This is an important distinction, for reasons we shall discuss shortly. But before we do, let’s take a moment to consider what it means to say that “every price is a relative measurement of market value”.

Let’s imagine that we are sitting at a table and I put on the table a one-dollar note and a banana. Next, I tell you that the market value of the banana is three times that of the one-dollar note. In other words, one banana is three times more valuable than one one-dollar note.

What is the price of the banana?

It’s not a trick question: the answer is three dollars. But why is the price of the banana “three dollars”?

Let’s think about it in terms of our earlier discussion. Both of the items on the table possess the property of “market value”. The banana has market value. The one-dollar bill has market value. We know this must be the case. Why? If one of the goods does not possess the property of market value, then we can’t compare them: we can’t say that “one banana is three times more valuable than one one-dollar bill” unless both the banana and the one-dollar bill have value.

In this example, the banana is three times more valuable than the one-dollar bill. If I wanted to buy the banana from you, I would have to offer you three dollars in exchange for the banana. This ratio of quantities exchanged (three dollars for one banana) is the price of the trade and it is determined by the relative market value of the two goods being exchanged (the banana is three times more valuable than the dollar).

The price of the banana, in dollar terms, is a relative measurement of market value: the market value of bananas (the primary good) as measured in terms of the market value of money (the secondary good).

The simple notion that “price is a relative measurement of market value” implies that the price of a good, in money terms, can rise either because (1) the market value of the good rises, or (2) the market value of money falls.

But, how do we know if a price rise is caused by the first factor or the second factor? In order to assess this, we need a standard unit of measurement for market value. In other words, we need a theoretical and invariable unit of measure that can be used to measure whether the price has risen because (1) the market value of the good has risen, or (2) the market value of money has fallen.

Unfortunately, there is no “standard unit” for the measurement of market value in economics. Perhaps one reason for this is because there is no good that possesses the property of invariable market value. Human economic relationships are constantly changing and our resources are constantly changing, therefore there is no good, nor unit money, nor unit of labor that possesses the property of invariable market value.

But, that doesn’t mean we can’t create a theoretical standard unit of market value that we can use to measure the market value of any good or currency in the absolute. Just as we have created theoretical standard units of measure for length, weight and speed, so we can create a theoretical standard unit of measure for the property of market value.

The Enigma Series proposes the introduction of a standard unit for the measurement of market value. For lack of better name, this standard unit of market value is called a “unit of economic value” or “EV” for short.

You might ask: “how much is a unit of economic value”? Frankly, it doesn’t matter. We are not going to run around the farmers’ market measuring the market value of goods in EV terms. Rather, our standard unit of market value is a theoretical tool, a tool that can help us think about challenging theoretical problems in economics such as price determination and inflation.

Once we have a standard unit for the measurement of market, we can do a lot of interesting things with it. For example, we can clearly illustrate how “price” is a relative expression, or a “ratio”, of the market value of two goods.

Imagine that we have two goods, good A and good B. Now, imagine that we can measure the market value of good A in terms of our standard unit (units of economic value) and we denote this “absolute” market value of good A as “V(A)”. Now, imagine that we do the same thing with good B and denote the absolute market value of good B as “V(B)”.

The price of good A, in terms of good B, can now be expressed in two ways. We can express the price in the traditional way, as a ratio of the two quantities exchanged, or we can express the price as a ratio of the absolute market value of the two goods.

The slide above implies that the price of good A, in good B terms, can rise either because (1) the market value of good, as measured in the absolute, rises, or (2) the market value of good B, as measured in the absolute, falls. In terms of our earlier example, the price of a banana (good A), in money terms (good B), can rise either because the market value of bananas V(A) rises or because the market value of money V(B) falls.

Where this idea gets really interesting is that it allows us to illustrate that every price is a function of two sets of supply and demand. The slide below illustrates how the price of good A, in good B terms, is determined by both supply and demand for good A and supply and demand for good B.

The key to this illustration is our “standard unit” of measurement for market value. We can use this standard unit for measurement on the y-axis to plot supply and demand for both goods independently.

The view of The Enigma Series is that every price is a function of two sets of supply and demand. In simple terms, if price is a relative measurement of the market value of two goods (the market value of a primary good relative to the market value of the measurement good) and if the market value of a good is determined by supply and demand, then every price must be determined by two sets of supply and demand.

We will explore this theory of microeconomic price determination in greater detail next week. For now, the key point that I want to make is that the adoption of a standard unit for the measurement of market value could open up a lot of very interesting theoretical pathways for the science of economics.

“Real” is not “Absolute”

There is a view among some commentators that the real price of a good is somehow an absolute measure of the market value of that good.

It isn’t.

The “real price” of a good is itself a price and, by definition, a relative measure of market value, not an absolute measure of market value.

In order to understand this concept, we can break it down into two simple parts. First, what is a “real price”? Second, what is required for something to be an “absolute” measurement?

The “real price” of a good measures how the price of a good changes in terms of the price of the basket of goods. The price of the basket of goods is also known as the “price level”.

For example, if the price of a banana triples, while over the same period the price level doubles, then we can say that the “real price” of the banana has increased by 50%.

The concept of “real prices” is a very useful concept. But, a real price is not an absolute measure of the market value of a good.

As discussed, in order for a measurement to be considered an “absolute” measurement, we need to use a “standard unit” of measure. Something can only act as a “standard unit” of measure if it is invariable in the property that it is being used to measure.

The price level is not invariable. The price of the basket of goods changes significantly over time.

Moreover, and perhaps more importantly, the basket of goods is not invariable in the property of market value. As discussed earlier, the market value of goods is constantly changing. Moreover, an average of the market value of a basket of goods is also constantly changing. Therefore, the basket of goods is not invariable in the property of market value and can not be used as a standard unit for the measurement of the property of market value.

Closing the loop, a “real price” is itself a “price”. The “real price” of bananas is simply the price of bananas in terms of the basket of goods. If the market value of the basket of goods is variable, which it is, then the “real price” is merely another form of relative measurement.

Share this:

Share this:

Share this:

Share this: