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:
- 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”);
- The market value of a good is determined by supply and demand for that good; therefore,
- 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”.
This 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.
In 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.