• The view of The Money Enigma is that current microeconomic models of price determination provide a limited and very one-sided view of the price determination process. In this week’s post, we shall explore the theory that every price is a function of two sets of supply and demand. More specifically, the price of one good (“the primary good”) in terms of another good (“the measurement good”), is determined by both supply and demand for the primary good and supply and demand for the measurement good.

• The traditional microeconomic view is that price is determined by supply and demand for one of the goods being exchanged (the “primary good”). For example, the traditional view is that the price of apples is determined by supply and demand for apples. However, in every transaction, there are two goods that are exchanged.

• For example, in a barter economy, we might exchange two bananas for one apple. So, does the price of this trade (the ratio of bananas for apples) depend upon supply and demand for apples or supply and demand for bananas? The answer is both.

• We can apply this concept to the determination of “money prices”. In a money-based transaction, we exchange one good (the primary good) for money (the measurement good). The price of the primary good, in money terms, is a function of both supply and demand for the primary good and supply and demand for money (the measurement good).

• The notion that “every price is a function of two sets of supply and demand” provides us with a universal theory of price determination: it is a theory of price determination that can be applied to the determination of any price: good/good prices (barter prices), good/money prices (“money prices”) or money/money prices (foreign exchange rates).

• In order to illustrate every price as a function of two sets of supply and demand, we need to understand the measurement of “market value”. In last week’s post, we examined what a “price” is. It was argued that every price is a relative measurement of market value: the market value of one good (the “primary good”) in terms of the market value of another good (the “measurement good”).

• Furthermore, we discussed the notion that market value can be measured in the absolute. In order to measure a property in the absolute, you need a “standard unit” of measurement. It was proposed that economics should adopt a standard unit for the measurement of market value called “units of economic value”.

• We can use this standard unit to plot how supply and/or demand for a good might react to changes in the absolute market value of that good (the market value of the good as measured in terms of our “standard unit”). Rather than plotting supply and demand with price (a relative measure of market value) on the y-axis, we can plot supply and demand using our “standard unit” on the y-axis (an absolute measure of market value).

• Importantly, this allows us to plot supply and demand for both goods that are being exchanged independently. We can then examine whether a change in the price of the primary good, in terms of the measurement good, is due to a change in supply and demand for the primary good or supply and demand for the measurement good.

The view of The Money Enigma is that every price is a function of two sets of supply and demand.

What this means, in simple terms, is that the price of one good, in terms of another good, depends upon supply and demand for both goods.

Furthermore, this principle holds true in a money-based economy. The price of a good, in terms of money, depends upon both supply and demand for the good and supply and demand for money (the monetary base). Notably, supply and demand for money (the monetary base) determines the market value of money, not the interest rate.

There are two ways to explain this theory. First, there is a simple, intuitively appealing and fairly non-technical way to think about the issue. Second, there is a far more technical path that requires an understanding of the issues discussed in last week’s post “The Measurement of Market Value: Absolute, Relative and Real”. Let’s begin with a simple overview of the theory and think about how prices are determined in a barter economy.

Price Determination in a Barter Economy: A Simple Overview

Price determination in a barter economy may seem like a strange topic to discuss in a world where nearly all transactions are conducted with money. However, analysing the process of price determination in a barter economy allows us to get back to basics and really think about the issues involved.

If we can understand how prices are determined in a barter economy, then this provides us with a basic model that we should be able to extend into a money-based economy. Furthermore, a comprehensive theory of price determination should be able to explain not only the determination of prices in a money-based economy, but also the determination of prices in a barter economy with no money and no accepted medium of exchange.

Let’s imagine a barter economy with no accepted medium of exchange (no good is used as “money”) and think about how prices are determined in that economy. For example, let’s try and answer this question: “how is the price of apples determined in a barter economy?”

Already, we have a problem. What do we mean when we say “the price of apples” in the context of a barter economy?

In a money-based economy, we would normally assume that the question refers to the price of apples in money terms. However, in our barter economy, there is no money and no good that is used as money. So, exactly what is “the price of apples” in the context of a barter economy?

There are many different ways to express the price of apples in a barter economy. We could express the price of apples in terms of bananas, or in terms of rice, or in terms of any other good that is widely traded in that economy.

The key point here is that the price of apples must be expressed in terms of some other good. Why? Every price, including the “price of apples”, is a ratio of two quantities exchanged: a certain quantity of one good for a certain quantity of another.

Let’s choose bananas as our second measurement good, the good that we use to measure the price of apples and let’s ask the question again: “how is the price of apples, in banana terms, determined in a barter economy”?

Now we have a meaningful question to answer. But before we do, let’s restate the question. As discussed, every price is a merely a ratio of two quantities exchanged. So let’s rephrase the question this way: “how is the ratio of exchange between bananas and apples determined in a barter economy?”

Does the ratio of exchange, “bananas for apples”, depend upon supply and demand for apples, or does it depend upon supply and demand for bananas? The answer is both.

For argument’s sake, let’s assume that the current ratio of exchange in our barter economy is two bananas for one apple (the price of apples, in banana terms, is two bananas). What are the factors that might influence this ratio of exchange?

What would be the impact of a sharp reduction in supply of apples upon the ratio of exchange? For example, if the apple crop failed and apples were in short supply, then, all else remaining equal, what would happen to the ratio of exchange “bananas for apples”? Clearly, the price of apples, in banana terms would rise: you would have to offer more than two bananas in order to get your hands on an apple, apples now being in short supply.

This example sits well with mainstream theory. A reduction in the supply of apples will increase the price of apples.

Now, let’s try a different scenario. Once again, let’s assume the ratio of exchange is two bananas for one apple. What happens if, all else remaining equal, there is a sharp reduction in the supply of bananas?

Let’s step back and think about this. Imagine a new parasite damages most of the banana tress and the supply of bananas is cut dramatically. All else remaining equal, do you think it would still be possible to swap one apple for two bananas? No. There is a shortage of bananas and bananas are now more valuable. Therefore, you would expect that one apple might only be able to obtain one banana, rather than the previous two bananas. Perhaps you might even need to offer two apples to buy one banana.

The point is that our ratio of exchange, bananas for apples, depends upon both supply and demand for apples and supply and demand for bananas. The problem for mainstream economics is that our example implies that the price of apples (the ratio of bananas exchanged for apples) depends upon supply and demand for bananas!

So, how do we resolve this seemingly awkward situation?

At a high level, the answer is simple. All we need to do is to recognize the general principle that the price of one good, the “primary good”, in terms of another good, the “measurement good”, depends upon both supply and demand for the primary good and supply and demand for the measurement good.

In the case of our example, the price of apples (the “primary good”), in terms of bananas (the “measurement good”), depends upon both supply and demand for apples and supply and demand for bananas.

The harder issue that we need to address is how do we illustrate this? How do we show the price of apples, in banana terms, as a function of two sets of supply and demand?

This brings us to the more technical part of our discussion. In order to understand how every price can be illustrated as a function of two sets of supply and demand we need a better understanding of what a “price” is and how the property of “market value” can be measured.

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

In order to understand how every price is a function of two sets of supply and demand, we need to step back and think about the concept of “price”.

So far, we have discussed the widely accepted notion that every price is a ratio of two quantities of exchanged: a certain quantity of a measurement good for a certain quantity of a primary good.

This definition is fine, but it doesn’t tell us much about the process of price determination. Rather, we need to think about the concept of “price” in more fundamental terms. More specifically, what does the price of a good, in terms of another good, indicate to us about the relative economic relationship that exists between the two goods?

Let’s return to our apples and bananas example for one moment. If the ratio of exchange in our barter economy is two bananas for one apple, then what does that imply about the value of apples relative to the market value of bananas? Clearly, it suggests that one apple is worth twice as much as one banana.

In slightly more technical terms, we can say that the market value of one apple is twice the market value of one banana. The apple possesses the property of “market value”. Similarly, the banana possesses the property of “market value”. The price of apples, in banana terms, reflects the relative market value of the two goods being exchanged (the market value of apples relative to the market value of bananas).

Therefore, we can say that “price” is a relative measurement of the property of “market value”. All economic goods (including money) possess the property of market value. A “price” is one method of measuring the market value of a good: it measures the market value of a good in terms of the market value of another good. For example, if the price of an apple, in banana terms, is two bananas, then this implies that an apple has twice the market value of a banana.

The observation that “every price is a relative measure of market value” is interesting because it suggests that there is an alternative way to measure the property of “market value”: the alternative method is measuring market value in the absolute.

Before we think about measuring market value in the absolute, let’s think about what is required to measure any physical property in the “absolute”. We discussed this topic at great length in last week’s post “The Measurement of Market Value: Absolute, Relative and Real”. While the topic may seem a little abstract, it is a critical concept to this theory of price determination and I strongly encourage you to read it.

By convention, in order for a measurement to be considered an absolute measurement, it must be made using a “standard unit” of measurement. For example, in order to measure the height of a tree in an absolute sense, we need a standard unit of measurement for height, such as inches.

Standard units of measurement have two critical properties. First, they must possess the property that they are used to measure. Second, they must be invariable in that property.

There is a third property common to most standard units: they tend to be theoretical in nature. For example, there is no such thing in nature as “one inch”. We made it up. The reason most standard units are artificial/theoretical is because almost nothing in nature is invariable.

This is true of the market value of goods. No good possesses the quality of invariable market value. Therefore, no good can act as a “standard unit” for the measure of market value. This is also true of money (currencies). No currency possesses the property of invariable market value.

So, how do we measure market value in the absolute? We need to create a standard unit for the measure of market value. Since no standard unit for the measurement of market value exists in nature, we need to make one up. In last week’s post, I proposed that we introduce a standard unit called a “unit of economic value”. “Units of economic value” are invariable measures of the property of market value, just as feet and inches are invariable measures of the property of length.

Adopting this standard unit for the measurement of market value is important because it allows us to demonstrate two critical points.

First, it allows us to illustrate how the price of a primary good, in terms of a measurement good, is a relative expression of the market value of both the primary good and the measurement good.

Consider our earlier example, the price of apples in banana terms. Let’s assume that we measure the market value of apples using our new standard unit. We can now measure the market value of apples in the absolute and denote this as V(A). Furthermore, we can separately measure the market value of bananas using our new standard unit and denote the absolute market value of bananas as V(B).

The price of apples, in banana terms, is a relative measurement of the market value of apples V(A) and in terms of the market value of bananas V(B). For example, if the market value of an apple is twice that of a banana, then the price of apples, in banana terms, is two bananas. Mathematically, the ratio of quantities exchange, the quantity of bananas Q(B) for a quantity of apples Q(A), is simply the reciprocal of the ratio of the two absolute market values.

The slide above implies that the price of apples, in banana terms, simply depends upon the market value of apples relative to the market value of bananas. All else remaining equal, if the market value of apples V(A) rises, then the price of apples will rise. Conversely, if the market value of bananas V(B) rises, then the price of apples, in banana terms, will fall.

We can extend this to a money-based economy. In a money-based economy, the market value of money is the denominator of every “money price”. All else equal, if the market value of money rises, then prices will fall. If the market value of money falls, then, all else equal, prices will rise.

The second important use for our standard unit for the measurement of market value is that it allows us to demonstrate how every price can be illustrated as a function of two sets of supply and demand.

As discussed, the price of apples, in banana terms, depends upon both the market value of apples V(A) and the market value of bananas V(B). How is the market value of a good determined? Supply and demand!

The market value of apples V(A) is determined by supply and demand for apples. The market value of bananas V(B) is determined by supply and demand for bananas. The price of apples, in banana terms, is a relative expression or a ratio of these two market values. Therefore, the price of apples, in banana terms, is determined by two sets of supply and demand.

This illustration of the price determination process is  useful because it allows us to isolate and analyze how changes in either market (the market for apples or the market for bananas) may impact the price of apples as measured in banana terms. For example, an increase in supply of bananas will lower the market value of bananas V(B). If nothing changes in the market for apples (the market value of apples V(A) is constant), then the price of apples, in banana terms, will rise as a result of an increase in supply of bananas.

We can extend this paradigm to the determination of money prices by simply replacing one measurement good (bananas) with another measurement good (money). The price of apples, in money terms, is determined by both supply and demand for apples and supply and demand for money.

It should be noted that this concept sits in stark contrast to traditional Keynesian theory. Keynes’ liquidity preference theory suggests that supply and demand for money determines the interest rate. The view of The Money Enigma is that this is wrong. In order for prices to be expressed in money terms, money must possess the property of market value. Supply and demand for money determines the market value of money. In turn, the market value of money is the denominator of every “money price” in the economy.

Before we finish this week’s post, I want to make one final point. This theory of price determination can be neatly reconciled with the traditional illustration of supply and demand taught in economics textbooks.

The traditional view is that the price of a good is determined by supply and demand for that good. Economists illustrate this by using “price” on the y-axis. This view of the price determination process is fine as long as it is recognized by the user that this traditional illustration of the price determination process implicitly assumes that the market value of the measurement good is constant.

For example, in our barter economy, if we assume that the market value of bananas is constant, then when we plot supply and demand for apples we don’t need to use our theoretical standard unit for the measurement of market value on the y-axis. Rather than using a theoretical invariable measure of market value (units of economic value) we can simply use an assumed invariable measure of market value (the market value of bananas).

While it may not be explicitly acknowledged, most textbook illustrations of price determination simply assume that the market value of the measurement good (most commonly “money”) is constant. This is perfectly fine if the assumption is acknowledged. However, this traditional view of supply and demand provides most students with a very one-sided view of the price determination process.

The view of The Money Enigma is that every price is a function of two sets of supply and demand. The current mainstream view that price is a function of one set of supply and demand is a primary source of many misconceptions in economics, most notably, the poorly conceived notion that supply and demand for money determines the interest rate.

If you would like to learn more about these theories then please visit the Price Determination section of The Money Enigma.

Author: Gervaise Heddle, heddle@bletchleyeconomics.com