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Price Determination in a Barter Economy

How are prices determined in an economy with no money? Let’s put that question another way. How are prices determined in a genuine barter economy where there is no commonly accepted medium of exchange?

You might think that this would be one of the first issues discussed in a standard microeconomics textbook. After all, once we can understand how prices are determined in an economy with no money, then surely we can extend this paradigm to price determination in a modern economy that does use money.

You would be wrong.

Microeconomics textbooks avoid this problem like the plague, and with good reason: mainstream economics today does not offer a sensible model of price determination in a barter economy. It is this failing to understand price determination at its most basic level (at the level of a barter economy) that has led to the one-sided perspective of price determination that is taught today.

The view of The Money Enigma is that every price is a relative expression of two market values. Moreover, every price is a function of two sets of supply and demand: supply and demand for the “primary good”, and supply and demand for the “measurement good”.

Price Determination Theory

Nowhere can this theory be more clearly illustrated than in a barter economy.

In our modern society, we take it for granted that prices are expressed in money terms. A bunch of bananas might cost $3, while a can of beans might cost $1.50. But it wasn’t always so.

Before the introduction of fiat currencies, and before the widespread use of gold and silver as a medium of exchange, prices weren’t expressed in terms of “x dollars” or “y coins of silver”. In a genuine barter economy, with no commonly accepted medium of exchange, every good would have hundreds, if not thousands, of different prices.

For example, in a genuine barter economy, the price of one apple might be measured in terms of cups of rice, handfuls of beans or a certain number of bananas. It is impossible to say what “the price of apples” is without making an explicit reference to the other good that is being traded. We can’t say the price of apples is “three”. The price of apples may be “three bananas”, but it may only be “one cup of rice”. In a barter economy, every good has a whole set of different prices reflecting the fact that its price can be measured in terms of a whole range of other goods.

So, how are all these different prices determined in a barter economy? For example, what determines the price of apples in a barter economy? A modern-day student of economics would probably answer “supply and demand for apples”. But this misses a critical point: there are many different prices for apples. For example, does supply and demand for apples determine the price of apples in banana terms or the price of apples in rice terms?

Clearly, the answer is more complicated than just “supply and demand for apples”. The correct answer is that every price is determined by two sets of supply and demand: supply and demand for the “primary good” (in this case, apples) and supply and demand for the “measurement good” (in this case, that might be bananas or rice or some other good).

The price of apples (the “primary good”) in banana terms (the “measurement good”) depends upon the market value of apples and the market value of bananas. The reason for this simple: price is a relative expression of the market value of two goods. The market value of apples is determined by supply and demand for apples. The market value of bananas is determined by supply and demand for bananas. The price of apples in banana terms is a relative expression of these two market values. Hence, the price of apples in banana terms is determined by two sets of supply and demand. This is illustrated in the diagram below.

Price Determination Barter Economy

The trick to illustrating this concept is recognizing that market value can be measured in both absolute and relative terms. In the diagram above, the market value of both goods is measured in absolute terms. In other words, the y-axis in both diagrams above uses an invariable measure of market value to measure the market value of apples on the one hand and bananas on the other hand.

Unfortunately, the measurement of market value in absolute terms is a difficult concept for most people to understand (it is a concept explored at length in The Inflation Enigma). So let’s think about price determination in a barter economy in more simple terms by answering the following two-part question. In a barter economy with no commonly accepted medium of exchange:

  1. How is the price of apples in banana terms determined?
  2. How is the price of bananas in apple terms determined?

These are both perfectly valid questions that microeconomics should be able to answer. In a barter economy, the price of every good can be expressed in terms of every other good (every good other than itself). Apples will have many prices, one of which is the price of apples in banana terms. Similarly, bananas will have many prices, one of which is the price of bananas in apple terms.

The simplistic and incomplete answers to the questions above would be:

  1. The price of apples is determined by supply and demand for apples.
  2. The price of bananas is determined by supply and demand for bananas.

Can you see what is wrong with these two answers?

The problem is that they are, in effect, different answers to the same question.

The price of apples in banana terms is merely the reciprocal of the price of bananas in apple terms. For example, if the cost of one apple is three bananas, then the cost of one banana is one third of an apple.

The answers given above suggest that one set of market forces (supply and demand for apples) determines the first price and another entirely different set of market forces (supply and demand for bananas) determines the second price. But this simply can’t be the case. Both prices must be determined by the same set of market forces because the two prices are merely different ways of saying the same thing.

So, let’s try again. What determines the price of apples in banana terms? Is it supply and demand for apples, or is it supply and demand for bananas? The answer is both. The price of apples in banana terms is determined by both supply and demand for apples, and supply and demand for bananas.

Price Determination Barter Economy

Conversely, the price of bananas in apple terms is determined by both supply and demand for bananas and supply and demand for apples. It must be because this price is merely the reciprocal of the “apples in banana terms” price. In terms of the diagram above, the price of bananas in apple terms would be denoted P(BA) which is equal to V(B) divided by V(A).

What makes this theory really interesting is that we can extend this model of price determination to a money-based economy.

Imagine that over time, bananas become accepted as the medium of exchange in our barter economy. Suddenly, we can speak of the value of all things in “banana terms”. Does the adoption of a medium of exchange change the way that prices are determined? No. The price of apples, in banana terms, is still determined by supply and demand for apples, and supply and demand for bananas. All that has happened is that bananas are now “money” (at least in one sense of that term).

The implication of this is that supply and demand for money determines the market value of money, the denominator of every “money price” in the economy. This is true whether money is bananas, gold or the fiat currency that we use today.

As a consequence, we can say that the price of apples, in money terms, is determined by both supply and demand for apples and supply and demand for money. This is illustrated in the diagram below.

Price Determined by Two Sets Supply and Demand

Price determination in a barter economy is an important subject. If the great minds of economics had spent more time thinking about price determination in a barter economy (rather than buying into the myth that is Keynes’ liquidity preference theory), then I believe that we would have a far better understanding of price determination and inflation than we do today.