- 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”.