• The basic economic theory of supply and demand is one of those beautiful scientific ideas that can be used to explain a complex process in relatively simple terms. But does this traditional representation of microeconomic price determination overly simplify the price determination process by ignoring half of the picture? In our eagerness to simplify and explain the price determination process, have we become too comfortable with a glass that is only half full?

• The view of The Money Enigma is that traditional supply and demand theory is a glass half empty. More specifically, the theory of supply and demand, as it is taught today, presents a one-sided and misleading view of the price determination process.

• The good news is that supply and demand theory is a glass half full: a theory that has important things to say about the price determination process. Moreover, it is a theory that can be adapted to present a more complete view of the price determination process.

• However, from a more critical perspective, the traditional representation of supply and demand, with price on the y-axis, is a glass half empty: a theory that ignores an entire market process in its rush to present a simplistic view of how a price is determined.

• In a nutshell, the problem can be described as follows. Price is a relative measure of market value. By definition, this implies that every price is a relative measure of the market value of two goods. Traditional supply and demand analysis focuses on changes in the market value of only one of the goods being exchanged and assumes, at least implicitly, that the market value of the second good (the “measurement good”) is constant. At best, this represents a glass half full approach to price determination: at worst, it is a misleading glass half empty approach.

• In any exchange, there are two goods: a primary good and a measurement good. The price of the primary good, in terms of the measurement good, is a relative measure of the market value of both goods.

• Supply and demand for the primary good can determine the market value of the primary good, but it can not determine the market value of the measurement good. Rather, the market value of the measurement good is determined by supply and demand for the measurement good.

• Consequently, if price is a relative measure of the market value of both goods, then every price must be determined by two sets of supply and demand: supply and demand for the primary and supply and demand for the measurement good (see first slide below).

• Traditional supply and demand analysis implies that the price of the primary good, in terms of the measurement good, is solely determined by the supply and demand for the primary good. While this model may be useful for the purposes of classroom demonstrations, it does not represent a comprehensive model of the price determination process.

• Moreover, by ignoring an entire market process (i.e., supply and demand for the measurement good) it is a model that has led to many misconceptions in economics, most notably, the idea that supply and demand for money determines the interest rate.

Overview & Introduction

In this week’s post, we will focus on the theory that every price is a function of two sets of supply and demand. This is a theory that is best understood by example. Therefore, the first section of this week’s post will be dedicated to illustrating, by way of example, how prices are determined in a simple two-good barter economy. In the second section of this post, we will apply this theory to the determination of money prices.

What Determines the Price of Apples?

Most of us are so accustomed to the idea that the price of a good is determined by supply and demand for that good that it is hard to imagine how one price could be determined by two sets of supply and demand. So, what does it mean to say that “every price is a function of two sets of supply and demand” and how do we illustrate this concept?

Let’s start by examining the key elements of the slide below.

The first idea that I want to highlight is the formula in the small red box. There are two ways to explain the formula in the red box: there is a simple version and a more technical version.

Let’s start with the simple version. In essence, the formula highlighted in the red box above states that the price of one good, in terms of another good, is simply a measure of the relative market value of the two goods.

What does this mean in layman terms?

Well, imagine that good A is apples and good B is bananas and that we live in a barter economy (an economy with no money). The formula in the red box above simply states that if one apple is twice as valuable as one banana, then the price of apples in banana terms is two bananas.

In terms of the notation above, if the market value of an apple “V(A)” is twice the market value of one banana “V(B)”, then the price of apples in banana terms “P(A_B)” is two bananas.

This shouldn’t be a controversial concept. If an apple is twice as valuable as a banana (“valuable” in the sense of market value), then I would have to offer you two bananas in order to buy one apple from you. Therefore, the price of apples in banana terms is two bananas.

If it helps, try thinking about this idea in “money terms”. If one apple is twice as valuable as one dollar, then the price of an apple is two dollars. If a year later, one apple were three times as valuable as one dollar, then the price of an apple in dollar terms would have risen to three dollars.

In more technical terms, if we can measure the market value of each good in the economy in terms of a “standard unit” for market value (a unit of measure that is invariable in the property of market value), then the price of the primary good in terms of the measurement good can be expressed as the ratio of the market value of the primary good divided by the market value of the measurement good, where the market value of each good is measured in terms of the standard unit (see slide below).

Now that we have a basic formula for “the price of apples in banana terms”, our job is to figure the mechanics by which the price of apples is determined. More specifically, what are the key market forces that determine the price of apples in banana terms?

Our simple price equation suggests that there are two different sets of market forces that we need to consider. One set of market forces determines the equilibrium market value of apples “V(A)”. Another set of market forces determines the equilibrium market value of bananas “V(B)”. The price of apples in banana terms “P(A_B)” is determined by the combination of both sets of market forces.

Clearly, one of set of market forces that would impact the price of apples is supply and demand for apples. Why is this the case? Well, let’s think about what happens if there is an increase in the demand for apples.

An increase in the demand for apples shifts the demand curve for apples to the right. All else remaining equal, the equilibrium market value of apples V(A) rises.

What happens to the price of apples in banana terms? Well, if the market value of apples rises, then apples are now more valuable relative to bananas than they were previously. Price is a relative measure of market value: therefore, the price of apples in banana terms must rise. In terms of our formula, if V(A) rises and there is no change in V(B), then P(A_B) must rise.

This scenario is easily captured by traditional supply and demand analysis. On the right hand side of the next slide, the market for apples is expressed in traditional terms with “price” on the y-axis. An increase in demand for apples shifts the demand curve to the right and the equilibrium price of apples rises.

Now, what is the difference between the market forces depicted on the left hand side of the slide above versus those depicted on the right hand? The answer is “nothing”: both diagrams are saying exactly the same thing. The only thing that is different about these two diagrams is the unit of measurement on the y-axis.

On the left hand side, market value is measured in “absolute terms”, i.e. in terms of a theoretical good (a standard unit of market value, denoted “EV”) that is invariable in the property of market value.

On the right hand side, market value is measured in “relative terms”, i.e. in terms of a good (bananas) that is variable in the property of market value.

The fundamental problem for traditional supply and demand analysis is that the traditional model must assume that the market value of the measurement good (in this case, bananas) is constant. This is, at best, a glass half full approach. Why? In the real world, the market value of the measurement good is never constant.

In order to see why the traditional representation of supply and demand is compromised, let’s think about what happens to the price of apples in banana terms when there is an increase in demand for bananas.

If there is an increase in demand for bananas, then the demand curve for bananas will shift to the right. All else remaining equal, the market value of bananas V(B) will rise. Again, this shouldn’t be controversial: if there is more demand for something and no corresponding increase in supply, then that thing becomes more valuable.

So, if the market value of bananas rises, then, all else remaining equal, what happens to the price of apples in banana terms?

The price of apples falls!

All else remaining equal, if there is more demand for bananas, then bananas become more valuable. If price is a relative measure of market value and the market value of the measurement good (bananas) rises, then, all else remaining equal, the price of the primary good (apples) in terms of the measurement good (bananas) must fall.

This simple concept is easily demonstrated in the slide above where supply and demand for both goods are plotted independently, i.e. in terms of a standard unit of market value. An increase in demand for bananas leads to a rise in the market value of bananas, V(B) rises: if the market value of apples V(A) is unchanged, then the price of apples in banana terms P(A_B) falls.

Frankly, this should be simple stuff. So, how does traditional supply and demand analysis illustrate this concept? The answer is “with difficultly”.

The traditional representation of price determination for apples implies that the price of apples is determined solely by supply and demand for apples. Therefore, according to this paradigm, what happens to the price of apples as expressed in banana terms if there is an increase in demand for bananas? The answer, it would seem, is nothing.

But, as we just discussed, this is the wrong answer. Supply and demand for bananas is a critical determinant of the price of apples if the price of apples is expressed in banana terms!

So, how can traditional accommodate changes in the market value of the measurement good?

Well, the first step is to explicitly recognize that traditional supply and demand analysis assumes that the market value of the measurement good is constant. Therefore, if the market value of the measurement good changes, then both the supply and the demand function need to be rebased to reflect the change in the market value of the measurement good.

In terms of our example, if the equilibrium market value of bananas rises, then the supply and demand curves for apples, where the supply and demand functions are both measured in banana terms, must both shift lower. Consequently, there is no change in the quantity of apples sold, but the price of apples in banana terms falls.

Once again, let’s ask the question: in the slide immediately above, what is the difference between the supply and demand functions illustrated on the left hand side and the supply and demand functions illustrated on the right hand side?

The answer is nothing: both sets of supply and demand functions are identical. The only difference between the two diagrams above is the unit of measurement, i.e. the way in which the market value of apples is measured.

While it may seem like a strange concept given the shift in the curves on the right hand side, we can say that in both cases, there has been no change in the market for apples. Supply and demand for apples, as measured in terms of an invariable unit of market value, has not changed. However, our representation of the market for apples, as depicted on the right hand side, must change. Why? Supply and demand for apples, as measured in price terms, must change because the value of the unit of measurement (the market value of bananas) has changed.

In summary, the view of The Money Enigma is that using “price” on the y-axis of supply and demand diagrams creates a misleading view of the price determination process. Rather, the y-axis unit of measurement should be a standard unit of market value, a unit that is invariable in the property of market value. In this way, supply and demand can be represented in absolute terms, an act which allows us to isolate whether changes in the price of a primary good, where that price is measured in terms of a measurement good, are due to changes in the market value of first good (the primary good) or the second good (the measurement good).

Those readers who are interested in learning more about the difference between the absolute and relative measurement of market value should read a recent post titled “The Measurement of Market Value: Absolute, Relative and Real”.

Now, let’s think about how this theory of price determination can be applied to the determination of prices our money-based economy.

The Determination of “Money Prices”

In the context of a barter economy, the key advantage of plotting supply and demand for the primary good and the measurement good separately is that it allows us to isolate whether a change in the price of a primary good, in terms of a measurement good, is due to a change in market forces for the primary good or due to a change in market forces for the measurement good.

For example, in terms of our “apples and bananas” example, plotting the market for apples and bananas in standard unit terms allows us to determine whether a rise in the price of apples is due to a rise in the market value of apples or a fall in the market value of bananas.

However, this theory isn’t just relevant to a barter economy. The notion that every price is a function of two sets of supply and demand has important implications for price determination in a money-based economy.

More specifically, it is an idea that forces us to focus on the role of the “market value of money” in the determination of “money prices” (prices as expressed in money terms) and, perhaps more importantly, how the market value of money is determined.

The idea that the “value of money” matters to the determination of prices is not something that you will see discussed at length in economics textbooks. There is a good reason for this: economics does not recognize the “value of money” as an independent variable. I won’t go into a lengthy discussion of why this is the case, but it boils down to the fact that economics doesn’t recognize how to measure the property of “market value” in absolute terms. In simple terms, if you don’t measure market value in absolute terms, then you can’t isolate the value of money as an independent variable, an issue that is discussed at length in a recent post titled “The Value of Money: Is Economics Missing a Variable?”

However, by tracing the evolution of price determination from a barter economy to a money-based economy, we can see why supply and demand for money must determine the market value of money (not the interest rate!). Furthermore, we can see that the value of money is, in effect, the denominator of every “money price” in the economy: all else remaining equal, as the value of money falls, the price of goods as expressed in money terms will rise.

Let’s go back to our original diagram: “Every Price is a Function of Two Sets of Supply and Demand”.

In a genuine barter economy, an economy with no accepted medium of exchange, this model of price determination implies that the price of apples in banana terms is a function of both supply and demand for apples and supply and demand for bananas.

Now suppose that our barter economy expands to have multiple different goods. Does this principle of price determination change? No. The price of one good, in terms of another good, depends upon supply and demand for both goods. Our pricing system may have become more complex because a matrix of prices begins to develop, but the principle regarding how each price is determined does not change.

Now imagine that one of the goods in our economy is a rock called “gold”. What determines the price of apples in gold terms? Is it (a) supply and demand for apples, (b) supply and demand for gold, or (c) both?

The answer is “(c), both”.

The price of apples, as measured in gold terms, is a relative measure of the market value of apples versus the market value of gold. Therefore, the price of apples in gold terms depends upon both supply and demand for apples and supply and demand for gold.

Does it matter that this rock called “gold” is, over a period of time, called by a different name, i.e. “money”? No. Gold must possess the property of market value in order for prices to be expressed in “gold terms”; moreover, the market value of gold must be determined by a market process, namely “supply and demand”.

The notion that supply and demand for gold/silver matters to the determination of prices in gold/silver terms is supported by historical experience. For example, during The Spanish Price Revolution, a period that began in 1470 and lasted until 1650, prices as measured in gold and silver terms rose dramatically (prices increased roughly sixfold over 150 years). This period of time coincides with a dramatic influx of gold and silver from the New World (Bolivia and Mexico).

In terms of our model of price determination, as the supply of gold and silver increased, the market value of gold and silver fell. Therefore, the price of other goods, as measured in gold/silver terms, rose: in a relative sense, other goods became “more valuable”.

Now, let’s fast forward to the introduction of “representative money”. Representative money is paper money that is explicitly backed by gold or some other real asset. Should our principle of price determination suddenly change? No.

Representative money, the first form of paper, only had value because it was a contract that promised to deliver gold. The value of this paper money moved in lockstep with gold. Therefore, we can say that the value of this paper money was determined by supply and demand. Moreover, as the value of gold fell, the value of paper money fell and prices, as expressed in money terms, rose.

At some point, the explicit promise that backed paper money was removed and “representative” money became “fiat” money. Should this shift from representative money to fiat money entirely change the principle of price determination? The simple answer is “no”.

In order for fiat money to act as a medium of exchange, store of value and medium of account, fiat money must possess the property of market value. Why fiat money has value is a complex issue that we have discussed in several recent posts including “The Evolution of Money: Why Does Fiat Money Have Value?”

Nevertheless, fiat money must possess the property of market value for us to express prices in money terms and, at the most fundamental level, it is the process of supply and demand that determines the equilibrium market value of money. 

The view of The Money Enigma is that supply and demand for fiat money determines the value of fiat money. More specifically, supply and demand for the monetary base determines the market value of money, as illustrated in the diagram below.

The price of a good, in money terms, is a relative measure of the market value of that good and the market value of money. The equilibrium market value of a good is determined by supply and demand for that good. The equilibrium market value of money is determined by supply and demand for money. The price of a good, in money terms is a function of two sets of supply and demand: supply and demand for the good itself and supply and demand for money.

If you would like to read more about this theory of price determination, then please visit the Price Determination section of this website. This theory is also discussed at length in a recent post titled “A New Economic Theory of Price Determination”.

Author: Gervaise Heddle