Tag Archives: 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

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.

Price as Ratio of Two Market Values

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.

Price Determination Theory

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.

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.

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

In last week’s post, we reviewed the theory that price is a relative expression of two market values. For example, the price of bananas, in money terms, depends upon both the market value of bananas and the market value of money. If the market value of bananas rises, the price of bananas rises. Conversely, if the market value of money rises, the price of bananas falls.

In more technical terms, we explored the idea that the price of one good, as measured in terms of another good, depends upon both the market value of the first good (the “primary good”) and the market value of the second good (the “measurement good”).

This week we will extend this idea and explore the theory that every price is determined by not one, but two, sets of supply and demand: supply and demand for the primary good, and supply and demand for the measurement good.

In simple terms, the key elements of this theory can be described as follows:

  1. Every price is a relative expression of two market values (the market value of the “primary good” and the market value of the “measurement good”);
  2. The market value of a good is determined by supply and demand for that good; therefore,
  3. Every price is determined by two sets of supply and demand, namely, supply and demand for the “primary good” and supply and demand for the “measurement good”.

Price Determination TheoryThis universal theory of price determination is illustrated in the diagram opposite.

The price of good A in good B terms, denoted P(AB), is a function of the market value of good A, denoted V(A), and the market value of good B, denoted V(B). Supply and demand for good A determines the market value of good A, V(A). Supply and demand for good B determines the market value of good B, V(B). Therefore, 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.

Some readers may be thinking that this just can’t be right. After all, doesn’t supply and demand for a good determine its “price”, not its “market value”?

The key point that I would make here is that the model above is compatible with the standard supply and demand theory taught at college. The “price” of a good is just one way of measuring the “market value” of that good. More specifically, the “price” of a good is the market value of that good as measured in terms of the market value of another good.

Traditional supply and demand analysis, with “price” on the y-axis, simply assumes that the market value of the “measurement good” is constant. We want to be able to relax that assumption and analyze the impact on the price of a good if supply and/or demand change not just for the “primary good”, but also for the “measurement good”.

In order to understand how it is possible to represent a price as a function of two sets of supply and demand, we need to think about the different ways in which the property of “market value” can be measured.

Market value can be measured in absolute or relative terms. We are so accustomed to thinking of market value in relative terms (in terms of a “price”) that we struggle with the notion that market value can be measured in absolute terms. But all properties can be measured in either absolute or relative terms.

For example, let’s think about the property of “height”. The property of height can be measured in either absolute or relative terms.

Let’s imagine that we have a girl standing next to a tree. The tree is three times taller than the girl.

Typically, we might measure the height of the girl in inches. An “inch” is an invariable and universal measure of height. Similarly, we can measure the height of the tree in inches. By measuring the height of the girl and the tree in inches, we have measured the height of both in terms of an invariable and universal measure of height. In this sense, we have measured the height of both the girl and the tree in “absolute” terms.

But there is another way to measure the height of either the girl and/or the tree and that is in “relative” terms. For example, we could measure the height of the tree in girl terms. The tree is three times taller than the girl. Hence, the height of the tree, in girl terms, is three girls.

Similarly, we could measure the height of the girl in tree terms. The girl’s height is one-third of a tree.

Does the girl’s height change if we measure it in “absolute” terms (in terms of inches) or in “relative” terms (in terms of the tree)? No. The girl’s actual height doesn’t change. All that has changed is the way in which we measure her height.

We can apply this same principle to the property of “market value”.

“Market value” is a property of economic goods (goods that are traded in our economy). If goods do not possess “market value”, then they are not traded and there is no price for them.

The market value of goods can be measured in absolute terms or in relative terms. Typically, we measure the market value of goods in relative terms. More specifically, we measure the market value of most goods in terms of the market value of money. For example, a banana is twice as valuable as one dollar and hence the price of a banana is two dollars. This “price” is a relative expression of the market value of bananas relative to the market value of money.

However, we can, at least theoretically, measure the “market value” of each good in absolute terms. Just as we measure height in absolute terms, in terms of an invariable measure of height such as inches, so we can measure market value in terms of an invariable measure of market value.

However, since no good possesses the property of invariable market value (the market value of all goods varies over time), we need to create some theoretical measure of market value that is invariable. The Inflation Enigma proposes a standard for this called “units of economic value” or “EV” for short. Units of economic value are just like feet or inches, except that instead of measuring the height of an object, they measure the market value of a good.

Once we have created this standard and invariable measure of market value (“units of economic value”), we can measure the market value of all goods, including money, in absolute terms. More importantly, we can illustrate supply and demand for each good in absolute terms.

Price Determined by Two Sets Supply and DemandIn the diagram opposite, the price of good A in money terms is illustrated as a function of two markets. On the left hand side, supply and demand for good A determines the market value of good A. Note that the unit of measurement being used on the y-axis is not money (a relative measure of market value) but units of economic value (an absolute measure of market value).

On the right hand side, the market value of money is also being measured in terms of our theoretical and invariable measure of market value (units of economic value). Supply and demand for money determines the market value of money (not the interest rate!).

The price of good in A, in money terms, is a relative expression of both the market value of good A and the market value of money. Therefore, the price of good A is determined by two sets of supply and demand: supply and demand for good A (the “primary good”) and supply and demand for money (the “measurement good”).

Let’s quickly examine what happens if there is an increase in demand for good A. If demand for good A increases, the demand curve for A (on the left hand side of the diagram) will shift to the right and the equilibrium market value of good A will rise. Furthermore, if the market value of money is constant (there is no change on the right hand side of our diagram), then the price of good A will rise.

This is the standard outcome generated by traditional supply and demand analysis. In this sense, the model above is perfectly consistent with traditional microeconomic theory.

However, what happens if demand for money increases? In this scenario, the demand curve for money (on the right hand side of the diagram) shifts to the right and the market value of money rises.

Now, what happens to the price of good A in money terms? The price of good A falls.

There has been no change in supply and/or demand for good where supply and demand are expressed in terms of our invariable measure of market value. However, the price of good A will fall because the market value of the measurement good (money) has risen.

The theory that every price is determined by two sets of supply and demand is one of the key theories developed in The Inflation Enigma, the second paper in The Enigma Series.

It is important to note that this theory is a universal theory of price determination. It can be applied to price determination in a barter economy (“good/good” prices), price determination in a money-based economy (“good/money”) prices) and foreign exchange rate determination (“money/money” prices).

The Inflation Enigma extends this microeconomic theory of price determination to a macroeconomic theory of price level determination called the “Ratio Theory of the Price Level”. Ratio Theory is particularly helpful in framing discussions regarding the causes of inflation.

Inflation or Deflation: A Microeconomic Perspective

In this week’s post we shall consider a basic question: “why does the price level rise and fall?” This might seem like a simple question, but a roomful of economists probably couldn’t agree on a succinct answer to that question.

Rather than entering into an extended macroeconomic debate about the causes of inflation, we shall attempt the answer the question “why does the price level rise and fall?” by considering the issue from a microeconomic perspective.

More specifically, we shall consider a couple of the key microeconomic ideas developed in The Enigma Series, namely:

  1. “Price” and “market value” are not the same thing; and
  2. Price is a relative expression of two market values.

The key to understanding inflation (a macroeconomic phenomenon) is a comprehensive theory of price determination (a microeconomic phenomenon). After all, if we understand how one price is determined, then surely we should be able to understand how many prices are determined?

While many inflation commentators prefer to jump straight into a discussion of macroeconomic variables (i.e., the output gap and oil prices), very few begin by answering a couple of the most basic questions in economics, namely “what is a price?” and “how is a price determined?”

If you ask most economists “what determines the price of a good?” the standard answer you will receive is “supply and demand for that good”. However, this represents a very one-sided view of the price determination process.

Price DeterminationIn contrast, the view of The Enigma Series is that every price is determined by two sets of supply and demand: supply and demand for the ‘primary good’, and supply and demand for the ‘measurement good’. More specifically, every “money price” is determined by two sets of supply and demand: supply and demand for the good itself and supply and demand for money.

Before you say, “that’s impossible” or “that’s not what I was taught at college”, let’s step back and answer the first question.

What is a price?

Every price is a ratio of two quantities exchanged. For example, x dollars for y bananas, is the price of bananas in dollar terms. This is a “good/money” price. But the same principle extends to barter prices, or “good/good” prices, and foreign exchange rates, or “money/money” prices.

For example, in a barter economy (an economy with no money), the price of bananas in apple terms could be three bananas per apple. Again, it is just a ratio of two quantities exchanged (a quantity of bananas for a quantity of apples).

Similarly, a foreign exchange rate (i.e., the EUR/USD cross rate) simply represents the quantity of one currency exchanged for a certain quantity of another currency exchanged.

The point is that every economic transaction involves, at minimum, an exchange of two items (bananas for money, bananas for apples, Euros for US Dollars) and the “price” of the transaction is the ratio of the quantities of the two items exchanged.

Now, let’s move on to the more complicated second issue. How is this “ratio of quantities exchanged”, or “price”, determined?

In order to answer this question, it helps to think about what property a good must possess in order for it to “have a price”. For example, why does coffee have a price but sunshine does not? Most people would simply say that sunshine is “free”. But at a more fundamental level, the reason there is a price for coffee and not a price for sunshine is that coffee possesses the property of “market value”, whereas sunshine does not possess the property of “market value”.

For a good to have a price, it must possess the property of “market value”.

Frankly, this proposition should be rather obvious. What may not be as obvious is that for prices to be measured in terms of a particular good (the “measurement good”), that good (the “measurement good”) must possess the property of market value.

In other words, for any good (“good A”) to measure the market value of another good (“good B”), the first good (“good A”) must possess the property of “market value”. It is impossible to determine the price of B in A terms unless A possesses the property of market value.

Let’s consider our coffee versus sunshine example to illustrate the point.

If we chose to, we could measure the market value of all things in terms of coffee beans. For example, the price of bananas might be tens coffee beans, and the price of an apple might be six coffee beans. Coffee beans possess the property of market value and we can measure the market value of other items in the economy in “coffee bean terms”.

Now, could we express all prices in the economy in “sunshine terms”?

The short answer is “no”, but why?

Why is it impossible to express the price of apples or bananas or any other economic good in terms of units of sunshine? The reason that we can’t express prices in “sunshine terms” is because sunshine does not possess the property of market value.

Price as Ratio of Two Market ValuesAnd this brings us to our key point: price is a relative expression of market value.

In any simple two-good exchange, the price of the transaction depends upon the market value of the “primary good” and the market value of the “measurement good”.

If one unit of the “primary good” (for example, one banana) is three times as valuable as one unit of the “measurement good” (for example, one dollar), then the price of the primary good, in measurement good terms, is three units of the measurement good per one unit of the primary good (or, in the case of our example, three dollars per banana).

If the “measurement good” does not possess the property of market value, then we can’t express prices in terms of that good. We can only use money as a “measurement good” for our prices because it possesses the property of market value. Clearly, we can’t use sunshine as our measurement good (we can’t express prices in sunshine terms), because sunshine doesn’t possess market value.

So, let’s return to the main issue. What determines the price of one good, the “primary good”, in terms of another good, the “measurement good”? Is the price determined by the market value of the primary good, or is the price determined by the market value of the measurement good? The answer is “both”.

Price Determination Barter EconomyIn a barter economy, the price of bananas, in apple terms, depends upon both the market value of bananas and the market value of apples. The price of bananas, in apple terms will rise if the market value of bananas rises. More importantly, the price of bananas, in apple terms, will rise if the market value of apples falls.

Similarly, the price of bananas, in money terms, will rise if the market value of bananas rises or if the market value of money falls. If the market value of money falls, then bananas are relatively more valuable, even if they are not absolutely more valuable. Price is a relative expression of two market values. Hence, the price of bananas, in money terms, will rise if the market value of money falls (all else remaining equal).

Ratio Theory of the Price LevelWe can extend this microeconomic concept of price determination to a macroeconomic discussion of inflation.

In simple terms, rising prices across the economy can be caused either by (1) an increase in the market value of goods and services, or (2) a decrease in the market value of money.

Economic weakness and a fall in oil prices may contribute to a decline in the market value of goods. These are both deflationary pressures that act to lower “money prices” across the economy. However, both of these pressures could be more than offset by a decline in the value of money.

The problem with most “inflation or deflation” debates is that the participants don’t recognize the simple notion that price is a relative expression of market value. Any meaningful discussion must consider not only the forces acting upon the market value of goods (oil price, output gap, etc.), but also the forces acting upon the market value of money (expectations regarding future output growth and base money growth).