Introduction to Exchange

Exchanges provide us with the objective information we need to make affirmative statements about market activity and what drives it.

Exchange, a simple concept on the surface, has broad and profound implications in economic theory. All economic activity—all market activity—consists of exchanges. People, individually, exchange one condition for another—sleep for wakefulness, food for hunger, uncleanliness for cleanliness, and more. Cooperatively people exchange services for goods, goods for services, services for services, and goods for goods, and these exchanges form a network of interactions we refer to as a market.

Exchanges provide us with the objective information we need to make affirmative statements about market activity and what drives it. We can say what goods actors prefer over other goods. We can identify the breakdown of the division of labor. We get an understanding of comparative advantage. And more….

In spite of the objective information derived from exchanges, we must take care to not misinterpret that information. Prices, for example, provide significant data, but they do not give us a precise measure—or indicator—of value. We can only say definitely that the parties to the exchange valued what they received more than what they gave. So, a price—whether in terms of a money commodity or goods—does not give us a “market value,” as so many would say. Prices only provide an indication of actors’ preferences at a particular point in time. We can only assume that those preferences will not change significantly in the short-term. I should repeat: a price does not measure value.

I also need to make a clear distinction between “buying and selling” and “exchange.” “Buying and selling” make internal references. Whether a person buys or sells depends on their Individual perspective. “Exchange” makes an external reference. It does not matter whether one adopts the perspective of one actor, another, or an outside observer. These relationships are analogous to “left and right” and “north and south.” North and south remain the same regardless of perspective. Left and right, however, depend on the direction a person faces.

I have made the above comments as an introduction to exchange and its importance. I will break down the types of exchange in the next post or two.

Subjective Value

See how, for you, every determination of value results from your own subjective judgment…

I have described, in earlier posts, some of the underlying concepts of the “Subjective Theory of Value.” In summary, individuals determine economic value subjectively and individuals establish their own measures of value based on subjective scales of preference. Individuals reveal their preferences, without precise units of measure, when they make an exchange.

These simple principles provide the basis for a complex system of values and action which create a network of relationships we refer to as a market. I will describe many of these complexities, and how they relate to market activities in future posts, but, for now, I want to sketch out an hypothetical situation that I hope will help you relate to the role of subjective value in your own actions.
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John wanders the streets of the art village in search of a picture to decorate his living room wall. He encounters a store called “The Same Price Art Store”. The sign in the window says, “All art the same price,” and it quotes a price well within his budget. He steps inside.

As he enters the store he is immediately impressed by the quality and selection of the art on display. Almost instantly, however, he notices some of the works that will not fit the decor of his home. He quickly sorts through the remaining selection and purchases an attractive landscape photograph.

So, what does this shopping experience have to do with economics, free markets, and value?

Shopping for artwork provides a good example of the real source and measure of value—and hopefully one to which you can relate.

First, John subjectively places relative values on all the art and ranks a particular piece of art above the rest. He has no other source for that value other than himself—whatever scale he places on that value.

Second, he has created a unique measure of value. He has a preference for a particular piece of art over all the others available at The Same Price Art Store. Since all pieces have the same monetary price, in this scenario, money price plays no role in the choice of art. (I will explain the role of money in future posts.)

Fourth, by acting on his preference, he has created objective evidence of his preference. For the first time during his shopping trip observers can see, by John’s actions, that he prefers that particular piece of art more than the other works in the shop and more than whatever money he given for the art.

This hypothetical example demonstrates how value originates with an individual and how the level of that value derives entirely from the ordinal preference scale of the individual.

Now, create your own example. See how, for you, every determination of value results from your own subjective judgment, and that you measure that value only in terms of your preference over alternatives available. Regardless of what sort of purchase or exchange you make—for fruit, smart phones, cars, clothes, or art—you alone determine what you value and how much.

Subjective value and ordinal preferences make quantitative economists rather uncomfortable. I will demonstrate in this journal that Subjective Value Theory provides the only logically consistent explanation for the establishment of economic value, which provides a basis for understanding all economic activity.

Money Not a Measure of Value

A dollar cannot represent the value for an item of less value than a dollar

Some people argue that money—or a monetary unit e.g. dollars, pounds, lira—plays the role as a measure of value. A money commodity cannot measure the value of economic goods because money commodities are also economic goods. To say that a dollar is worth a dollar becomes a statement of meaningless circularity. You cannot use the item being measured as a unit of measure.

But, why do we say things like, “that car is worth 23,000 dollars” or “that stock is worth 45 dollars”?

I suspect that the idea that a monetary good could represent a unit of value finds its origin in the mistaken idea that exchanges occur at an equilibrium of value.

I remember in my undergraduate economics classes trying to learn the concept of indifference curves. As I recall, if you calculate and plot the quantities at which persons don’t care (have an indifference) whether they have product A or product B you create an “indifference curve.” The curve expressing the indifference for A vs. B might represent the “supply curve” and the curve expressing the indifference for B vs. A might represent the “demand curve.” At the point where the supply curve intersects the demand curve each party values both goods the same—they have an indifferences at to which good they have. For some reason, according to classical theory, at that those quantities, they will want to make an exchange.

Forgive my somewhat confusing explanation, but it never made sense to me in the first place.

Classical economic theory makes this argument: that exchanges occur when the quantities of two goods reach an equilibrium of value. Thus, since we don’t have a unit of measure for value, it might seem fair to say that, when they are exchanged, A has the value of B, or vice versa. Based on that reasoning it would also make sense, when most exchanges involve a commonly accepted medium of indirect exchange (like a dollar), to replace that unknown unit of measure for value with the quantity of dollars exchanged.

This whole chain of reasoning, however, falls apart when we come to realize that exchanges do not occur at an equilibrium of value. When a person trades a dollar for a pack of gum, he makes that trade because he values the pack of gum more than the dollar. If the buyer valued the dollar exactly the same as the gum, he would have no reason to make the exchange. He will make the exchange only when he sees a greater value—no matter how small—in having the gum over having the dollar. Therefore, a dollar cannot represent the value for an item of less value than a dollar.

We should correct the hypothetical statements I made above: “to the buyer that car is worth more than 23,000 dollars” or “to the buyer that stock is worth more than 45 dollars.”

We also need to correct our understanding of widely publicized economic data. GDP for example: “GDP represents the monetary value of all goods and services produced within a nation’s geographic borders over a specified period of time.*” But, it does not.

More precisely GDP represents the total amount of money (in the local currency) spent for goods and services valued more than that amount of money exchanged by the individuals for those goods and services.

Think about it.

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* From InvestingAnswers: http://www.investinganswers.com/financial-dictionary/economics/gross-domestic-product-gdp-1223

Cost of Production Value Theory

Probably the most popular concept of value incorporates the cost of production. The idea here is that any economic good, whether a consumer good or production good, has value based on the sum of the costs of resources used to produce it. A loaf of bread, for example, would have the value of the sum of the cost of the labor to produce it, a portion of the cost of the stove used to cook it, all the costs associated with producing the flour, and presumably the cost of the land on which the wheat was grown.

Source

As appealing as the cost of production theory of value may seem, it does not hold up when you trace costs back to their origin. The production of all goods derive ultimately from combinations of land and labor — land provides all the resources used in production, and labor provides the original source of effort. Here we run head-on into the problem of intrinsic value. From where does land derive its value? Also, as mentioned above and in “Labor Theory of Value”, from where does labor derive its value?

This leads us again to the question of how do we measure the cost of production for any good?

Measure

It seems reasonable, on the surface, to sum the cost of the factors that contribute to the production of a good—labor, materials, and machinery—and use that as a representation of value. But, yet again, we run into some unresolved questions.

How do you measure the cost to produce the original factors of production—land and labor? I have addressed in “Labor Theory of Value” the difficulty in finding a satisfactory unit of measure for labor. Then, what unit do you use to measure the value of land?

Well, of course, we use the cost to the producers (what’s given up to acquire the land). But, if you work your way back to the original homesteader, what cost did he bear? And, did subsequent buyers and sellers make no profit or suffer no loss as the land got transferred to the present owner?

In addition to the difficulty of coming up with units of measure for land or labor individually, what unit do we use for both land and labor that we can sum to a meaningful total? You cannot add hours of labor and acres of land to arrive at the number of acre-hours as a unit of value. If you will forgive a touch of sarcasm, I simply wish to point out the difficulty of identifying a uniform unit for the measure of value—even for original factors of production.

This problem increases exponentially (I admit that I cannot suggest a unit of measure for the problem—consider it a figure-of-speech) with the introduction of multiple factors of production from different sources. Consider the consistency of establishing a uniform measure for the many parts used in automobile production. Many identical parts come for different parts of the country that have significantly different costs for land, labor, and lower level factors applied to them. Do Chevrolets with different parts, have different values?

You can see that using the cost of production does not provide a uniform source or a uniform measure for value.

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Before I move on to discuss the only plausible theory of economic value, I want to take a brief detour to address a question that many people seem to take as obvious: don’t we use money as a measure of value?

Money cannot act as a measure of value and I will give a few of the many reasons in my next post.

Labor Theory of Value

Source

Some people believe that, since all economic goods require some amount of labor to produce (even “free” goods require the labor to pick them up off the ground, pluck them off a bush, or capture them with one’s hands,) economic goods get their value from the labor required for their production.

Formal explanations of the labor theory of value frequently refer to the “total amount of socially necessary labor required to produce” the item. The theory also excludes the use or pleasure of the owner. This language, however, uses vague and abstract terms to explain the source of value—an already very abstract term.

But, from where does labor derive its value? The idea that labor puts value into goods implies that labor itself has some sort of intrinsic value that it can transfer to the economic good in the process of production. If labor has an intrinsic value, that would mean it had the same value when used to dig holes with no purpose as it did to plant crops that might feed a family or a village.

Whether labor has intrinsic value or acquires value for some other mysterious source, how does a person measure the value of labor?

Measure

What unit of measure do you use to value labor. Some have suggested using time is a measure of labor value. Thus, a product that required two hours to build would have a value twice that of a product that took one hour to build. Using time as a measure of value would mean that two cabinets, identical in every feature, would have different values because one cabinetmaker took twice as long to build his cabinet as the other cabinetmaker did to build his.

Even Karl Marx, the renown advocate of labor value, stumbled on this one.

Labor Theory advocates get around this pesky problem by saying value increases in proportion to labor performed with average skill and average productivity. But, in attempting to account for the inconsistency of time as a measure of value, theorists have injected the difficult task of measuring skill and productivity.

‘Round and ‘round they go.

So I turn the problem over to you, reader. If you believe that labor adds value to economic goods, explain the source and the unit of measure for that value.

Next, I will turn my attention to the “cost of production” theory of value.

Intrinsic Value

Believing that the value of a thing resides within an object or action seems like an easy approach at the outset. But the idea of intrinsic value falls apart, as do several of the value theories, based on our criteria: source and measure.

Source

The idea of intrinsic value argues that something in an object gives it value. Thus, an apple has a given value; an iPhone has a given value; a bar of gold has a given value; an automobile has a given value. And, somehow, all economic actors know of those values.

Each of those items may have inherent characteristics that separate them from the other items, but does that give them value that has any meaning in economic terms. The advocates of intrinsic value leave us with many unanswered questions. Here are only a few:

  • Does intrinsic value change with use? Does my iPhone have a different value if I use it as a camera, a word processor, or a paperweight?
  • Does intrinsic value change with form? Does the bar of gold have a different value if I have it converted into pieces of jewelry or electronic components?
  • Does intrinsic value change with stages of production? If iron ore has an intrinsic value, does it have the same value as it gets converted progressively into an iron ingot, a sheet of steel, and finally into an automobile body?

I think you can imagine other nagging questions, but each leads to the most troubling question: how do we measure intrinsic value?

Measure

The concept of intrinsic value really falls apart when the question of measurement arises. If economic goods get their value from within, how can we compare one economic good to another? What unit of measure do you use to compare the value of a peach with the value of an iPod, each of which gets its value from within.

One cannot compare the value (regardless of measure) of an apple and a shoe, if they have only intrinsic value. If a good has inherent value, what generalized unit of measure represents that value?

Weight, a characteristic of any object, for example, has a uniform measure that a person can use to compare one item to another e.g. 10 pounds of peaches compared to 10 pounds of iPods. You can see this distinction without getting involved in the physics principles of mass and gravity. But, value, unlike weight, has no distinct unit that can be used to compare one item with another.

For purposes of effective, efficient, economic action, value must have a common source and a common method of measure.

Conflicting Value Theories

In spite of the importance of value to the development of sound economic theory a lot of people disagree about the source and measure of value. I will touch on the more prominent value theories Over the next couple of posts.

But, before I move on to the discussion of the theories of economic value I have one point that I need to emphasize:

Money does not represent a source or measure of value of any sort.

In the future I plan to devote considerable space to discussing the nature and role of money. I may, in those future post, repeat some of these comments, but I need to clear away any doubts that readers might have that I have overlooked money as either a source or a measure of value.

Economic goods of one sort or another play the role of money. Those goods get traded in the same way that any other good gets traded. In their role as money they get traded as mediums of indirect exchange. That money role influences the source and the measure of their own value, but it has no bearing whatsoever on the value of the goods for which people trade them. The real source and measure of the value of money goods abide by the same parameters as all other economic goods—as I will discuss on detail later.

Thus, phrases like “worth 100 dollars” carry no validity in economic logic. When someone pays 100 dollars for an item, that action reveals that the person values the item more than they value the 100 dollars. It reveals nothing about how much more they value the item.

In the next several posts I will address some primary theories of value:

  • Intrinsic Value
  • Labor Value
  • Cost of Production Value
  • Subjective Value

I will show why only subjective value theory holds up to logical scrutiny.