Wage & Price Discovery

Socialists show reluctance to accept deferred payment or agree to absorb any losses. Even before they face those issues, how can they establish what portion of revenues they actually deserve? They cannot determine the price of the end product beforehand, and they cannot separate their real contribution to revenue. They have a real dilemma.

Value and Price of Product

Socialists don’t seem to understand that, even after having the capitalist subsidizes their wages during the production process, the market price for their wages remains unknown. The consumer has the final say on the price of the end product — the pencil. If the product sells for enough that the capitalist can replenish his subsistence fund and more, he will have profited from the risk he took. For the ongoing business, the replenishment of the subsistence fund allows the capitalist to repeat the process, which includes paying workers at every stage of production.

Yes, the capitalist does gain when he accurately estimates the price at which consumers will buy enough of the product to give him a profit. If, on the other hand, the market price — as established by consumers — does not replenish his subsistence fund. The capitalist will suffer a loss — even after workers have received their agreed upon wage.

Because consumers establish the value and price of products, it becomes impossible to, in any way, extrapolate the value of labor until after the sale of the product. Neither the capitalist nor the worker knows the market price of the product until after the sale.

A close up of a piece of paper Description automatically generated

Neither the value nor the price of any capital or labor involved in the production of the product in question can be determined until after a sale. Even then, the value of labor remains a subjective judgment on the parts of the capitalist on the one hand and the worker on the other hand. The capitalist prefers to pay as little as possible, and the worker prefers to get paid as much as possible. The actual wage — or price — results through the process of negotiation between the capitalist and the worker.

But, of all the ingredients that go into the production of a product, how can a person separate the value of labor alone?

Separating Price of Labor

If we assume that the product will sell for the same amount on the next cycle as it did the last, and we further assume the same amounts of capital and labor are used in the production on the next cycle, how can we extrapolate the proportion of that revenue that accrues to labor? If the socialists would only think about it, they would realize that we cannot determine the proportion that goes to labor.

As a socialist so readily point out, capital and labor must operate together to produce products. Either one without the other would produce nothing. Capital and labor represent two elements of a system — a system in which the whole produces more than the sum of the parts.

Because of the systemic nature of production, the contribution of the individual components cannot be determined separately. The person who contributes the most of the productivity of the manufacturing process is the person who designs the process, usually a person who is either a capitalist or works for a capitalist.

The Solution

Socialist face an economic dilemma. To achieve their ends of being paid “what they’re worth,” they must do all of the following:

  1. Defer payment and allow determination of wages until after consumers buy the product.
  2. Agreed to absorb a share of any losses incurred.
  3. Acknowledge that relative contribution to value is unknown and unknowable.
  4. Accept a negotiated wage after the fact.

In other words, for socialists to resolve the dilemmas created by socialism, they must become capitalists.

They should acknowledge the flaws in socialism and give it up as a failed system.

 

Socialism Would Pay Full Value

Socialists want full pay for their work. Would they delay that payment until completion of production? Would they agree to cover any losses after the sale of the product?

I recently view a video in which a student, who proudly identified himself as a socialist, confronted the speaker with the question: Why don’t workers receive payment equal to the full value of their labor contribution? Since capitalists cannot produce anything without labor, does it make sense that the capitalists should receive a premium — or a profit — above the value of labor? Shouldn’t workers receive the full value of their labor?

The question reveals ignorance on the part of questioner about how the system actually works. And, the speaker’s response, although accurate, did not answer the essence of the question.

I will fill in some of that gap.

Structure of Production

To fully understand why laborers do not receive a greater portion of the revenue received for the end product one must have a basic comprehension of the structure of production. The “structure of production” refers to the series of stages through which a product must pass before it becomes ready to offer to the final consumer.

Depending on the complexity of the final product that structure can extend backward through numerous stages and over a long time. The structure of production tends to exhibit far more complexity than most people expect. Whether by intent or not this conversation used pencils as an example, for Leonard E. Read wrote a marvelous piece titled I, Pencil…” in which he described the complex process of bringing an everyday item like a pencil to market.

Capital Investment

Comprehending the structure of production sets the stage for answering the question about worker pay.

Before he can begin the lengthy process required to bring a pencil to market, the capitalist must find a source of capital— which means not money or machinery but necessary resources to sustain the production process until it can offer the product to consumers. Some use the term “subsistence fund” to refer to those resources. To accumulate a subsistence fund someone — the capitalist — must deny himself an amount of current consumption for some time.

Using money as a medium of indirect exchange, the capitalist will transfer portions of the subsistence fund to workers at each stage of production. The workers receive all of their agreed upon wages from the capitalist before he sells the first unit of product — in this case, the first pencil. Before that sale, the investment represents a total loss for the capitalist. The worker has lost nothing; whether satisfied with his wage or not.

Capital Loss

Socialists, demanding the “full value of their labor,” never offer to go without pay during the lengthy production process. Furthermore, they never offer to absorb any losses incurred from the business venture.

They want full value now.

But how does anyone determine that value? I will address that question in my next post.

 

Systems Thinking in Economics

Systems Thinking helps people understand more clearly the complexity of markets.

You will probably hear me make several references to “systems thinking” in the process of explaining free markets. I thought that this post would be a good way to introduce systems thinking and its relevance to economics and free markets. To start off, I want to offer a concise definition of the system:

Definition

  • “A system is an entity which maintains its existence through the mutual interaction of its parts.” by the late Austrian Biologist Ludwig von Bertalanffy.

An accurate description of free markets fits perfectly with this definition. Markets become a unified system through the interaction of individuals making exchanges and not by an elaborate design imposed upon individuals.

As part of an introduction, I have borrowed “The Laws of the Fifth Discipline” from The Fifth Discipline by Peter Senge. I will give each of the eleven “laws” and provide my own description of how they apply to free markets.

  • “Today’s problems come from yesterday’s ‘solutions.’”

The presence of feedbacks represents one of the distinctive characteristics of systems. Many of the processes in systems create information that, when fed back into the system, change the input to the next iteration. Feedback becomes particularly crucial in human systems — i.e., systems that include humans as an element. For example, the system that includes both car and driver provides feedback to the driver so that he knows when to speed up, swerve, or brake.

The solutions that we apply to today’s problems simply shift the problem to a different time or space. The people who inherit the “new problem” frequently don’t recognize it as the return of an old problem.

This explains why many market interventions seem to address problems for which solutions have already been applied.

  • “The harder you push, the harder the system pushes back.”

Because systems contain “compensating feedback,” well-intentioned interventions frequently stimulate responses from the system that offset the benefits of the original interventions.

The higher lawmakers raise minimum wages, the higher the resulting unemployment.

The more lawmakers attempt to regulate segments of the market, the more frequent the occurrence of black markets or illegal activities.

  • “Behavior grows better before it grows worse.”

Any success at overcoming structural influence will only last for a short while. We find simple, “easy,” interventions enticing because they seem to work — in the short term. Then, again, compensating feedback takes over and things get even worse.

Economic stimulus gets people to spend more money. This causes a nominal increase in GDP. It also causes a lack of savings and investment resulting in a cutback in employment and reduced availability of goods in the future.

  • “The easy way out usually leads back in.”

Familiar solutions to apparently similar problems usually keep us mired in the same problem.

Adjusting tax rates to cure the “Social Security” problem eventually leads us back into the difficulty caused by the structure of this unsustainable “Ponzi” scheme.

Making significant structural changes to a poorly designed system will have more effect on eliminating recurring problems than making small changes to processes that only address symptoms.

  • “The cure can be worse than the disease.”

When we don’t account for the feedback from changes we make, we sometimes don’t see the full impact of our actions. Our central banking system increases the money supply to stimulate the seemingly slow economy. The misinformation sent by this artificial cure causes malinvestment, which leads to a depression worse than the apparent, but natural, slow down.

Sometimes the easy, familiar, solutions have no effect. Indeed, sometimes they become addictive and dangerous. By misguiding market players, monetary expansion creates an addictive dependence that eats away at healthy productive investment.

  • “Faster is slower.”

Remember the tortoise and the hare. Systems operate at the pace allowed by their structure. Pushing them too fast will cause delay or breakdown.

In our persistent efforts to create economic growth, we forget that the economy has a natural rate of growth. Rapid rates of business growth, brought on by market intervention, frequently outrun the capability of businesses to generate capital to support that growth. High rates of broader economic growth have the same effect. High rates of consumption eat away at capital growth, which slows future consumption.

  • “Cause and effect are not closely related in time and space.”

People intervening in market systems frequently commit the error of equating proximity of events with cause and effect. Human systems share the fundamental characteristic that cause and effect do not occur closely in time and space. We may not see the results of the actions we take today either in the same time or the same place. What appears like a sound expenditure now, may prove catastrophic when the effect finally reaches the market.

  • “Small changes can produce big results—but the areas of highest leverage are often least obvious.”

Chaos theoreticians speak of the “butterfly effect” in which a butterfly flaps its wings in some distant location causing a local storm in the future. Although this so-called “butterfly effect” serves mostly as a metaphor, it does give a sense of the importance of small events.

Frequently, the most obvious solutions either don’t work or make matters worse. Small, targeted, actions, however, can often produce significant and enduring changes. These high leverage actions do not seem apparent to the participants in the system. A one percentage point increase in the rate of saving might, through increased investment, improve long-term consumption by more than 15 percent.

  • “You can have your cake and eat it too—but not at once.”

Sometimes dilemmas only appear as opposing choices. For example, the false choice between “low cost” and “high-quality.” The short-term cost of higher quality may lead to both lower cost and higher quality in the long run.

The “low cost” bidding process employed by government frequently leads to the early crumbling of vital infrastructure.

  • “Dividing an elephant in half does not produce two elephants.”

As logical as it may seem, dividing a problem into smaller problems seldom works. If you have a big problem, you must treat it as such. You may have to take sequential steps to the solution, but you must coordinate these steps to solve the single problem.

The integrated, holistic, nature of living systems requires that they must remain intact to realize their full benefit. The whole equals more than the sum of its parts.

Governments build their reputations on promising half an elephant as if it were one elephant. Treating government spending and taxation as independent issues amounts to dividing the government interventionist elephant.

  • “There is no blame.”

We tend to blame outside influences. “Systems thinking shows us that there is no outside; that you and the cause of your problems are part of a single system. The cure lies in your relationship with your ‘enemy.’” (Senge page 67.) Don’t blame the people when they do the best they can within the system in which they operate.

When you encounter a surly government employee, remember they work for a system that does not recognize you as the customer. They owe their allegiance to other bureaucrats and politicians, not to you. You have no influence on a system that you do not pay directly.

Conclusion

Many the characteristics of systems seem counterintuitive, until you think about them. Human systems, such as markets, add a higher level of complexity. These systems reflect on the results of their own behavior and adjusted their behavior to achieve different results. In other words, they learn.

Interventionists simply cannot outsmart markets.

Reference

Senge, Peter M., The Fifth Discipline (New York: Doubleday), 1990

 

The Dangers of Modern Monetary Theory

At the core of Modern Monetary Theory (MMT) lies the implicit premise that the acquisition of money represents an end of itself. MMT bases its argument on what some people refer to as a “missing premise.” They present a proposition that contains an unstated premise that they assume everyone accepts. Give people more money, created out of nothing, and their spending will increase economic activity.

Although this premise seems quite appealing to many people, it contains a flaw that invalidates the entire theory.

Introduction

I first encountered MMT several years ago on one of the social media platforms. The people involved seemed almost fanatical about the idea, but I found it lacking logical consistency. For that reason, I thought the whole idea would die a natural death.

Recently, almost by accident, I have encountered several new references to MMT. This seeming resurgence may have occurred because one of the economic advisors for Bernie Sanders strongly advocates for MMT. In addition, I think that the rise in popularity in socialist ideas has given new vigor the conversation about MMT. People seem to like the idea — advocated by MMT — that you can receive things at no cost, e.g., medical care, schooling, retirement, etc.

I hope to point out, in this post, some of the weaknesses in the argument for MMT. To accomplish this, I would like to address just a few basic premises that the advocates of MMT either ignore or misunderstand.

  • They seem ignorant of the role of money as a medium of indirect exchange.
  • Demand does not exist in the aggregate or without the prior production of goods.
  • Double entry bookkeeping proves nothing about the results of expanding the money supply.

I cannot make exhaustive comments in the space that I have allotted myself. I only want to open your thought to some of the unanswered questions left by advocates of MMT.

The Role of Money

If you consult almost any textbook on economic theory, the author will describe money as a “medium of exchange.” This phrase, although accurate, does not explicitly portray the real role of money. Money actually acts as a medium of indirect exchange. Ignoring the importance of this fact brings MMT to its knees (as it does any theory about monetary manipulation adhered to by the Federal Reserve).

Any good that somebody exchanges for another good acts as a medium of exchange. The important distinction comes in identifying mediums of indirect exchange. With an indirect exchange, one party accepts a good for the purpose of exchanging it a second time for yet another good. That good has little or no value to them without the possibility of exchanging it for the third good. A medium of indirect exchange simply facilitates an otherwise goods-for-goods exchange. One must understand this distinction to comprehend the role of money clearly.

The single role of money consists of its use as a medium of indirect exchange. Unlike other goods, it never gets exchanged for the purpose of consumption. For that reason, the system requires no change in the quantity of money. It only requires, to accommodate declining money prices, that whatever good (or claim on that good) used for money can be divided almost indefinitely. The government or the banking system need not increase the quantity of money—for any reason.

In a market system, with goods prices based on money, the relationship of the goods-for-goods prices become distorted when the quantity of money changes arbitrarily. This price distortion forms the basis for economic malinvestment and boom and bust cycles, which wreak significant havoc on economic activity.

MMT (along with the Federal Reserve) ignore the critical importance of the real role of money. The ignorant use of monetary expansion leads to the economic boom and bust cycles addressed by the Austrian Business Cycle Theory.

Aggregate Demand

MMT relies to a significant degree on the concept of “aggregate demand.” This idea, popularized by John Maynard Keynes, claims that the government should stimulate an economy by doing something to increase aggregate demand. The idea of aggregate demand, however, represents a pure fantasy.

First, demand cannot exist without prior production. In the goods-for-goods exchanges facilitated by media of indirect exchange, some good must be given up in the acquisition of money. Without that good being given up, a reduction in the overall goods and services occurs. With the introduction of artificially created money, some traders find they have exchanged something for nothing. (For more insight, refer to “Increasing Demand Won’t Make the Economy Grow” by Frank Shostak.)

Providing money for nothing means that eventually, some buyer discovers that sufficient goods do not exist to complete transactions. But, we cannot know specifically what goods the economy lacks. Which leads to the second problem with aggregate demand.

Second, one cannot aggregate, or sum, the demand for a multitude of separate goods. You cannot add five chickens, two iPads, four Chevy Volts, etc. and derive a meaningful total. Summing the dollars exchanged in an economy gives no real information about the sum and substance of the goods exchanged.

Double Entry Bookkeeping

MMT advocates make a big deal about the importance of double entry bookkeeping and balance sheets. One person’s spending does indeed represent another person’s income. This tautological statement proves nothing regarding the validity of the argument for expanding the money supply to “stimulate demand.” It only means that in a double entry bookkeeping system debits and credits must always equal.

Since the entries in bookkeeping systems reflect quantities of money (both debits and credits), this only means that when somebody gives up money for a particular good, they record (as a debit) the amount of money given up. They do not record the quantity, or the characteristics, of the thing acquired.

Remember that money denominated double entry bookkeeping does not reveal what goods, if any, were given up to acquire that money. Although the books may balance, if the money used in the underlying transaction has been created ex nihilo (out of nothing), the transaction represents a fraud somewhere in the system.

Conclusion

The increasing popularity the socialism, and socialist politicians, leads me to believe that MMT presents a real danger. The danger lies in its appeal to people’s desire to get something for nothing. Socialism by itself cannot allocate economic resources effectively and efficiently. The implementation of what I would describe as a “free money policy” would only add to the misallocation of resources caused by the administration of a socialist system.

People need to learn the valid propositions behind sound money. We live in an environment in which people accept monetary expansion as a natural phenomenon. Artificial monetary expansion represents a stealthy form of violent intervention—it dilutes the purchasing power of personal property. Despite the problems with our current monetary system (also based monetary expansion), the system could be worse. The implementation of monetary policy based on Modern Monetary Theory would undoubtedly be worse than what we already have.

 

Linguistic Revision

The language used by economists confuses many people—including themselves. Imprecise usage of words and phrases leads to poor communication and flawed thinking. Test the meaning of everything you hear or read about economics and free markets.

I have lifted the title of this post from the title of a chapter in Science and Sanity by Alfred Korzybski. Korzybski deserves credit for establishing the discipline referred to as General Semantics. I may refer to General Semantics in future posts. General Semantics might be described as a discipline that studies the effect of language on human behavior. Korzybski talks about how changes in language can change people’s behavior and some parts of our language require change in order to stimulate new and more effective the behavior.

Korzybski refers to three important thinkers who have influenced our thinking through the ages and continue to today: Aristotle, Euclid, and Newton. The words that we use to describe the thinking of these three mental giants tend to lead us to linear, cause-and-effect, thinking. Korzybski advocates that based on the new knowledge about our world that we need to shift our language to reflect non-Aristotelian, non-Euclidean, and non-Newtonian, thinking. We now live in a world in which A is not always A, straight lines only exist in concept, and gravity no longer acts instantaneously over distance.

The language used in economics and the description of free markets still reflects the old linear, cause-and-effect, thinking. We need to learn how to use language more accurately in order to reflect the reality of the human systems we call markets.

Out of the many words used in economic lexicon I have chosen four to demonstrate how their usage can frequently confuse people’s understanding.

Value

Readers of my blog know that I make frequent references to value. I do so because it lies at the core of economic thinking.

Commonly economists refer to value as something that a person can measure, record, and calculate. The scientific use of value coincides with this meaning.

Economics, however, refers to human systems in which the word value takes on an entirely different meaning. In that context it becomes a subjective judgment limited to the mind of the individual. We cannot measure or calculate value. We can only measure human action based on value.

Demand

The word demand, in popular usage, has several different meanings. Economists make that meaning only slightly more precise, and in some cases totally confusing. In many cases they give the impression that the existence of more people creates more demand. They also described demand as something that can be plotted on a diagram to which suppliers will respond.

Demand only exists when a person brings something of value (to the other party) and offers it in exchange. Without something to exchange demand cannot exist. In addition, the notion that demand can be plotted ex-ante is almost ridiculous. Ask two people who just completed an exchange what the demand curve looked like before they made the exchange.

Aggregate

The word aggregate frequently appears in economic writing and conversation. Frequently economists refer to aggregate demand, aggregate income, or aggregate employment. The term conveys the underlying assumption that these generalized concepts can be summed in some meaningful way.

Summing individual demand, individual income, or individual employment, amounts to a mathematical or logical impossibility. The idea that we can add these things defies logic and insults the importance of individual responsibility and decision.

Inflation

If you look up the term “inflation” in an economics textbook or dictionary, you will usually find it defined as a general rise in prices. When economists start discussing the causes of these general rises in prices, they refer to things like wage inflation, consumer price inflation, or other types of price inflation.

A rise in the general price level (meaning a generalized increase in the prices of individual products) can, in fact, occur. But, the cause has only a single source: monetary expansion. Without an expansion of the money supply, when the price of one good goes up, the price of some other good or goods must go down.

Rising prices caused by monetary expansion create a distortion in the information flow transmitted by the mechanism of prices.

Interest

The concept of interest confuses a lot of people, including those involved in financial transactions. The traditional concept of interest relies on the relative productivity of capital. The productivity of capital does have an influence, but this really confuses the issue. It makes it a little hard to explain interest charged for the purchase of consumer items.

A simpler and more straightforward explanation of interest deals with time preferences. A good in the present always has more value than the very same good in the future. Thus, in order to entice a person to exchange a current good for a future good, a greater quantity of the future good must be offered. Interest consists of the difference between the amount of the current good and the amount of the future good in an exchange.

The reader should note that the amount of interest, and the interest rate, depend on the two independent variables involved in the exchange. No one can change interest rates independent of those two variables. The Fed, for example, cannot control interest rates.

Conclusion

Practitioners of the hard science have the luxury of creating new language to describe their principles and theories. After all, who do cosmologists speak to other than other cosmologists. Economists, on the other hand, do not have that luxury. They talk to other humans about human activities. Yet, they need to promote certain level of precision in the language they use.

When you listen to, or read, the words of an economist take care not to interpret what they say based on the normal meaning of those words. Do they give the same meaning to these words that you do? And, possibly more importantly, do they introduce a certain level of inconsistency into their own thinking by using the common meaning of the words?

I can’t expect to cause linguistic revision just by pointing out a few words that I call into question. But I would hope to encourage readers to question the words that people use in describing free markets. Do they really mean what you think they mean? Do they really make sense?

 

In closing, consider these two phrases:

Innocent until proven guilty.
Innocent unless proven guilty.

Which words would you use?

 

The Power of Preference

Preference has tremendous power because it guides all transactions in a market economy. The preferences of individuals govern all economic activity. You have power because of your preferences. Choose them with care.

For the most part we take our preferences for granted. After all, they are ours and ours alone. We get to choose whether we like yellow or blue. We get to choose whether we like hamburgers or fish sandwiches. And we get to choose whether we like iPads or Androids. But, those preferences don’t seem to affect anyone else.

Your preferences, however, play a vitally important role in your life and the lives of others. In your life those preferences determine what you wear, what you eat, where you live, and whom you choose to have as friends. When you go to the grocery store it matters to you whether you prefer oranges or bananas. It matters to you whether you buy raisin cookies or just raisins. How you act based on your preferences, of course, makes a difference in your life. But, what difference does it make in the lives of other people?

You don’t share preferences with other people. Your preferences belong to you only. You may have preferences similar to others, but you have chosen them for yourself. So again, what difference do your preferences make to other people?

Would you find it difficult to believe that market systems developed based on the preferences of many many individuals. The preferences of individuals represent the sole source for what we refer to as economic value. The preferences of individuals — or their subjective value — provide the basis for the value of anything bought, sold, or exchanged in a market economy.

Thus, the next time you or someone else makes a statement about the value or worth of the good offered for sale on the market, ask “In whose opinion?” Nothing has any economic value unless someone else prefers it to either what they have or what they have an opportunity to acquire.

Preferences have tremendous power. All economic activity occurs because of people acting on their preferences. In this blog, I will return frequently to the importance of preferences for two reasons:

First, because of its importance in effecting every economic activity; and
Second, because the truth of subjective value turns most economic models on their heads.

A Pricing Model

No one can build a model to either determine or predict prices, despite the useful information that prices provide. Attempts to predict prices will always prove fruitless.

Knowing prices in advance would prove useful to owners and managers in all businesses. Imagine the profitability a company that could accurately predict the future prices of its products. I will show that the best that we can do is interpret price patterns in order to make subjective judgments about market opportunities.

I will step through three different levels of models and explain their relative usefulness:[1]

  • Events
  • Patterns of Behavior
  • Market Structure

Events

Models to Determine Prices

Despite what they teach in basic economic classes a person cannot predict individual prices by finding the intersection of supply and demand curves. If you think about this for about 12 seconds, you will realize that no one has ever seen a supply or a demand curve. Economists draw these curves, after the fact, in an attempt to explain the behavior of buyers and sellers.

The fact remains that buyers act based on their scale of preferences and sellers must make reasoned guesses about what buyers might pay for their products. Business schools teach managers to make sophisticated models to develop offering prices based on their cost structure. That exercise, however, provides no guarantee that buyers will pay that price.

Patterns of Behavior

Models to Interpret Prices

Over a period of time patterns develop that indicate the prices upon which buyers and sellers agree. These patterns do not provide any prediction, but, based on the assumption that the past is an indication of the future, these patterns do provide some useful information.

Rising Prices

A pattern of rising prices provides significant useful information for entrepreneurs. A pattern of rising prices indicates relative shortages in a particular market and the possibility for profitable opportunity. If buyers willingly pay more and more for a good, it indicates that they have relative difficulty in finding that good. Entrepreneurs can exploit that opportunity. (See diagram below.)

Rising Prices

Declining Prices

Declining prices, on the other hand, indicate relative excesses in a specific market. Depending on the steepness of the decline entrepreneurs might decide to reallocate their capital to more profitable opportunities. (See diagram below.)

Declining Prices

Market Structure

Pricing Causal Loops

An accurate model of the market structure would provide the most accurate prediction of market prices. In the diagram below, I have sketched a conceptual model of a simple market structure. Briefly it would operate in the following sequence:

  1. Increases in production lead to increased inventory.
  2. Increased inventory leads to a reduction in production. These two steps create a balancing process. Additional reinforcing processes influence these two steps.
  3. Increased efficiency leads to reduced prices and increased production.
  4. Reduced prices lead to increased sales
  5. Increased sales reduce inventory leading to increased production.

If a modeler knew all these variables, he could accurately predict the behavior of the system.

Causal Loop

This model, however, has one fatal flaw. It represents a human system in which people act based on subjective judgments. As described in the section above no one can predict individual prices. We don’t know until after the fact what buyers will voluntarily pay for the goods in question.

When attempting to build models of markets, modelers make the mistake of assuming the patterns of behavior represent the mental models of buyers. (I.e. they confuse the map for the territory.) Prior to 2008 house prices rose consistently year after year for several decades. Market watchers mistakenly assumed that that trend would go on “forever.”

The preferences of individuals can shift suddenly, changing the structure of the market, creating entirely new patterns of behavior. No one can predict when these shifts in preferences will occur. No one can know when prices will change.

Conclusion

No reliable model for pricing can exist. Patterns of behavior provide the most useful models for interpreting market behavior. Rising prices generally signal shortages. Falling prices generally signal abundance. But, market participants must view these patterns with great caution.

In a free-market, buyers can shift their preferences relatively swiftly. But, in markets subject to intervention outside forces work to distort those preference scales, causing price distortions, misinformation, and the misallocation of resources.

  1. I base my statements on an assumption of no intervention in the market. I assume, for the sake of discussion, that fiscal redistribution, regulation, and monetary policy have no influence on market pricing. 

What’s It Worth?

The worth—or value—of any good is always unknown and unknowable. Use the consideration of this reality to trigger useful questions regarding market behavior.

If you have followed my posts to this point, you realize this question—”What’s It Worth?”—has only one answer: “The worth—or value—of any good is always unknown and unknowable.” Even an individual cannot quantify the worth of things he values. So, should this question always become a conversation ender?

No. Frequently pondering questions to which we have no answers plays as important a role in understanding as does having a ready answer. I will examine reflections on this unanswerable question at three levels:

  • Individual
  • Enterprise
  • Economy

Individual

When you pose the question” What’s it worth?” to an individual, what do you really mean? Since he cannot answer the question as phrased, you probably want to know what price he would pay for the item. What would he give up that he values less (usually in terms of money) to gain the item in question, which he values more? The answer always depends on his personal assessment. It may not work for you; but that does not make the answer wrong or right.

Enterprise

At the enterprise level the” What’s it worth?” question, again, generally refers to price—not value. In this case the” asking price” of an item usually results from a price discovery process in which a number of individuals, through individual acts of buying or not buying, signal how much they will voluntarily give up in order to acquire the item.

The price discovery process does not amount to a collective decision. Nor does it mean that the individual buyers have reached a consensus on a precise price for the item. It means that the asking price falls within a range in which the buyers willingly give up something—usually money—they value less than the item they buy.

Economy

The “What’s it worth?” question becomes a bit more complex when speaking of an economy. People use the Gross Domestic Product (GDP) as a common metric for the “value” of an economy. But does GDP provide any real indicator of value or even a measure of price? No.

It cannot indicate value because the diverse value judgments of millions of people regarding millions of items cannot represent a measure at any level.

GDP cannot provide useful information regarding prices. The varied prices of multiple goods simply cannot be aggregated. Just try to add the prices of hamburgers, autos, and cameras. You can’t do it.

So, is GDP a useless statistic? No. But, you must understand what it does measure. It simply measures the number of dollars exchanged for defined categories of goods. (GDP also suffers from logical flaws, which I will discuss in another post.)

Conclusion

Next time someone asks you,” What’s it worth?” stop and think. What does this question really mean? (You may not want to take the questioner through all your thought processes, but, the pause might clarify your own reasoning.)

Individually does this really refer to price?

For an enterprise, what range of value does the discovered price indicate? Can prices move up or down within a range within that range?

In an economy does the” value” metric provide useful information? Or, does it provide misinformation?

Consider the value of an unanswerable question.

The Importance of the Individual

The discrete nature of humans makes the individual the center of all market activity. They decide what has value and how much. Their actions based on those evaluations make free markets operate effectively and efficiently.

The subjective theory of value reveals that the individual plays the most important role in the development of all economic theory. The effective and efficient allocation of resources throughout an economy always depends on satisfying the needs and wants of individuals.

I will mention briefly some of the reasons why individuals are so important to understanding free markets:

Discrete Nature

Like all things in nature people will always remain separate. Individuals simply cannot form collectives. Communities of all sorts consist of networks of individuals. They have separate minds and the act separately. The subjective theory of value remains consistent with this fact.

Market Power

Because individuals provide the source and measure of value they also represent the predominant market power. All market transactions result from the actions of individuals. When organizations act, they do so as a result of the consensus of individual decisions.

The idea of individuals as a source of market power turns most economic theory absolutely on its head. Market power comes from the bottom of the hierarchy; not the top.

Inverted Cost Structure

The fundamental role of individuals inverts the popular model of market cost structure. The amounts that buyers willingly pay for goods and services determine the costs of retailers, distributors, and manufacturers, not the other way around. Goods cost what they do at every level of the production structure because of the demands of consumers for other products requiring the same resources.

When attempting to determine the cost of any good or service don’t look to the source of the resources used. Look to what buyers willingly give up to receive that good or service.

Determination of Market Prices

The bidding of individuals to purchase goods determine market prices. The competition between suppliers does not play the dominant role in holding down market prices. The bidding of individuals for goods actually stimulates competition between suppliers.

Determination of Wealth Distribution

Many people misunderstand the determination of the distribution of wealth. A good only has market value when individuals willingly offer something in exchange. The same holds true of the market value of resources. They only have value if they produce something for which individuals willingly exchange.

This fact holds true of the market value of financial assets. The ownership of a particular stock signifies wealth only because others desire to own that stock. Without legitimate demand — demand backed by substance — the stock becomes worthless.

Political Power

Like market power, individuals determine the source and level of political power. An individual gains political power when others delegate that person to exercise illegal or unauthorized force against another individual — or individuals. This does not change the original source of power i.e. the individual.

The role of the individual in the distribution of political power becomes important with a discussion of market intervention. I have previously defined free markets as those free of violent intervention—markets free of political power.

Conclusion

No process exists that eliminates the role of the individual in the operation of markets. Individuals determine what they value and how much they value it. No other source exists. As a result, the individuals reside at the center of the operation of any market.

I have only touched briefly on some of the aspects that make the individual so important to the development of economic theory. I will allude to the importance of the individual many times in the course of my blog posts.

Relationship of Value to Price

Value and price have a very close and important relationship. Value exists entirely in the subjective realm, whereas price provides objective evidence of an economic transaction. The price results from action taken based on value. It does not, as many people believe, provide a measure of value.

Value

As I have laid out in previous posts, value only exists as a subjective inference in the minds of individuals. It has no objective unit of measure — indeed the individual cannot quantify his own measure of value. An individual exposes his value preference only when he makes an exchange. When the individual makes an exchange he exposes his relative value to himself and anyone witnessing the transaction.

Exchange

When an individual encounters a good (A) that he values more than a good (B) that he owns he will seek to make an exchange. If the owner of good B values good A more than good B, these two individuals will make an exchange. The consummation of this transaction provides the proof that each party values what he gets more than what he gives up. If they don’t make the exchange, the original premise about who values what proves false. In other words, an exchange amounts to individual actions based on individual values. The result of that transaction provides objective evidence of the relative values of the two individuals. Keep in mind it only indicates relative values — in terms of more or less — and never quantifiable values. That evidence of value results in what we refer to as a price.

Price

The word price refers to the ratio of what a person gives up to what he receives. In other words, if Bill exchanges eight apples for four peaches, we can say the Bill’s per peach price equals two apples. A price only appears with the consummation of an exchange. If the owner of the peaches offers them at a ratio of three apples per peach, that does not amount to a price. It only amounts to an offer — or, if you will, an offer price. An exchange must occur in order to create a price. I realize that these examples seem almost ridiculously simple and somewhat unrealistic. Most transactions occur with the use of money and the price stated in terms of dollars and cents. Keep in mind that money simply exists as another good used as a medium of indirect exchange. The interpretation of “price” remains the same whether the transaction consists of a direct exchange — as in the case of Bill and his apples — or an indirect exchange — as with the use of money.

Interpretation

The price resulting from an exchange creates an objective indicator of the relative values for Bill and his exchange partner. After the exchange we can say with certainty that Bill values peaches more than apples. But, we still cannot quantify how much more Bill values peaches. Objective price information provides the basis for the development of effective and efficient allocation of resources throughout a market. When a price pattern develops in the market that indicates the existence of many buyers willing to trade apples for peaches at roughly the same ratio (price), peach producers who want apples know that a market exists for their produce. Money prices contain precisely the same information, however it can apply to a multitude of products exchanged indirectly. This information provides the foundation for economic calculation fundamentally important to the operation of free markets.

Conclusion

Knowing that people value goods on a individual subjective preference scale provides the basis for a sound fundamental theory of free exchange. It does not, however, provide us with any useful objective information. For useful information we must have the ratio of goods exchanged—which we refer to as price. By aggregating price data we can develop definitive statements about the relative values of the players in a particular market. We now know, with certainty, who values one good over another. Keep in mind that price does not measure value; it simply indicates the range of relative value. The price does, however, provide sufficient information for the effective and efficient allocation of resources in an economy.