- 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.
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.
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.