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.

 

Disrupting the Money Cycle

Artificial changes in the money supply always disrupt the money cycle and cause price disruptions that lead to production problems in otherwise normally functioning markets.

Introduction

The complexity of large markets makes the diagramming of market processes difficult at best. One must take great care in not overstepping the bounds of logic and systems thinking.

However, occasionally a small diagram can at least trigger questions that need to be asked about the system under discussion. In this article, I will discuss an extremely simple — possibly overly simple — diagram depicting the cycle of money in two markets.

First, I will describe the cycle of money in a free and voluntary market without monetary intervention.

Second, I will give a brief description of the market subject to monetary intervention.

My objective consists of getting you to ask more pertinent questions regarding assumptions about monetary expansion, used by the Federal Reserve system and strongly advocated by the modern monetary theorists.

Free Market

The ridiculously simple diagram that I have provided below should open your thinking to questions about the operation of a free and voluntary market.

In this diagram, I have represented three producers/consumers named Eddy, Joe, and Max. I think you can see already that this does not accurately portray the immense complexity of any market. But, bear with me, and I think this diagram will help me make a significant point.

I have identified the steps in this process by the circled numerals.

  1. Eddy, also the producer of Good1, finds what I refer to as Good0. (The quantity of this Good found by Eddy represents all that exists in the system.) This Good will, in this diagram, come to be accepted as a form of money—a medium of indirect exchange. I have used dollar signs to indicate money, but dynamics applies to any form of money.
  2. Eddy exchanges his newfound money with Joe for Good2, produced by Joe. Eddy consumes all of the Good2 that he has acquired. The cycle can repeat through time as long as Joe produces more Good2 in Eddy as a source for money. I will explain how Eddy gets money in the next few steps.
  3. Joe uses the money that he received in the exchange with Eddy for Good3 produced by Max. Joe consumes all of the Good3 that he acquires. Max now has money that he can use for exchange.
  4. Max exchanges his newly acquired money for Good1, produced by Eddy. Eddy now has money he can use to repeat the cycle, returning to step 2).

This diagram provides a terribly oversimplified model of the daisy chain of events that make up a market system. A real market will consist of billions of the exchanges similar to those depicted in this diagram, all connected in very complex ways.

Despite the oversimplification of the system depicted in this diagram, each individual transaction works precisely the same as a transaction in the real market. One person exchanges money for a Good he values more than the money he gives up. These individual exchanges provide the foundation of a complex system that provides effective price discovery and efficient resource allocation.

Two essential things happen during this cycle. First, the fixed quantity of money, first found by Eddy, has served for three transactions. The system has required no additional money. Second, each transaction has produced an objective money price — the ratio of money given to goods received. This money price will serve to inform the allocation of resources in future cycles.

For the sake of this example, each person in these exchanges requires the Good that he receives for his subsistence. If he does not receive that good, he will perish.

Monetary Intervention

I have modified the diagram given in the free-market example to demonstrate the effects of monetary intervention. The steps are very much the same as in the first example with one significant difference in step one.

  1. Instead of finding a Good that he can use as money, the government gives Eddy the money he needs to purchase the goods he requires. Eddy produces nothing. (Create your own reason why Eddy produces nothing to trade. Maybe he likes being on the dole.)
  2. Eddy makes the same exchange with Joe and consumes the Good that he receives.
  3. Joe makes the same exchange described above with Max and also consumes all of the Good that he receives.

Max now has all the money he requires to buy Good1 that he requires for subsistence. But, no one in this system now produces Good1 and Max perishes.

With the absence of Max, no Good3 exists to provide subsistence for Joe, who also perishes. With the demise of Joe, Eddy gets no Good2, and he also perishes.

Thus, with the injection of new money into the system, for the purpose of keeping it going, the process has reversed itself and the system has died.

Conclusion

I’m sure that you can see that I have left a number of factors out of this discussion to make it as simple as possible. For example, I have not addressed the effect of rising money prices caused by the addition of new money. And, I have not taken this example to any level of reasonable complexity.

I have created this example the sole purpose of raising one fundamental question: what happens when no one produces any Good to acquire the money that enters the system—regardless of source?

Very complex systems, unlike my oversimplified example, can absorb a large quantity of artificially created money before this question becomes significant. But, at some point, the system responds to this unanswered question.

In the case of the real estate crash that occurred in 2008, it had taken from 45 to 50 years for the money artificially funneled into real estate to wreak havoc on the market. The advocates of MMT want to create a perpetual hole in the production cycle through the artificial expansion of money that they propose.

Watch out for the free lunch. It could cost you everything.

 

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.

 

Healthcare Economics

Government involvement in “healthcare” provides startling example of an incredible waste of resources that no one seems to notice. It shows how a current benefit causes a long-term drag on the economy.

In my last post I pointed out how a vote for government amounts to a vote for economic inefficiency.

In this post I will point out some important questions regarding a specific intervention of government in the market — the intervention in “healthcare.”

The complexity of this subject precludes me from covering it in any detail. I would simply like to point out some of the issues that people seem to ignore when dealing with the subject.

Terminology

How can we discuss the subject intelligently without using accurate terminology?

We have for years used the euphemistic term “healthcare” to refer to what should more accurately be referred to as “sickness-care.” In common usage, people normally use the term healthcare to refer to prescription drugs, hospital stays, vaccinations, etc. These topics, however, have a great deal to do with sickness and very little to do with health.

Most people also seem to deny that this sickness-care is a product or service that should have a normal market price. Some people claim that they have a right to healthcare. By some magical activity it should be given to them with no cost. They don’t seem to understand that healthcare consists of a service like many other services—not much different from the service of a plumber or an auto mechanic. Natural law gives you the right to life. It does not give you the right to health; that’s up to you.

To prevent confusion on your part I will continue to refer to sickness-care as healthcare. I don’t want you tripping over too many new concepts all at once.

Prices-Costs

Price plays an important role in the allocation of all resources—even those used in a service like healthcare. But, what mechanism tells bureaucrats what to pay providers for medical treatment services? They have no way to effectively and efficiently allocate resources to such a valuable service because they have no price mechanism to observe. If they want a resource, they give up nothing to get it—unlike a consumer would.

The willingness of people to pay for healthcare should determine the price of medical care in the same way that people’s willingness to pay for gasoline determines its price. How much do you value your own health? What sacrifice would you make to maintain good health?

The government does not — indeed cannot — know the answers to these questions. And, providing the service free, or cheap, creates another set of problems.

Demand

Economists don’t agree on very much, but they nearly universally agree that providing a good for free, or cheap, leads to more demand.

More demand almost always leads to higher prices for the entity paying the bills. When government takes on the role of providing any service for people, the price, ultimately paid by taxpayers, tends to rise. Look at the many activities in which government intervenes e.g. schools, union wages, postal service, real estate, etc. The prices rise faster than the rest of the market. The same thing happens to the cost of healthcare.

With free healthcare people tend to have more doctor visits, more visits to the ER, and more demand for prescription drugs. Since government does not know the value of any of these services, they have no way of knowing how much to provide nor at what cost.

Allocation

Ever-growing demand with the lack of an effective pricing mechanism leads to an inefficient allocation of medical resources. As with most government activities, providing healthcare amounts to a redistribution from the healthy and productive to the sick and less productive. This redistribution causes a drag on rest of the economy that affects all consumers. Without these pricing mechanisms, how can bureaucrats know who should get what treatment and when?

This principle—mis-allocation due to lack of price signals—applies particularly to what has become a political talking point: pre-existing conditions. Who defines the meaning of pre-existing conditions and determines who has them? Then, who pays for the treatment of those pre-existing conditions. As indicated above the healthy and more productive people pay for the sick and less productive.

The resources taken involuntarily from productive activities actually create a negative feedback for the sick themselves. The long-term source of the philanthropic support of those with serious conditions gets diminished by current taxation and transfers to the ill.

Enough resources do exist to help those who really need long-term financial assistance for their medical needs. Individuals, however, not the government should decide from where those resources come. The government, by confiscating people’s resources, insult the voluntary kindness of people and their willingness to help people in need. People with pre-existing conditions would not die in the streets without government stealing on their behalf.

Conclusion

Healthcare, like any other service, should be left to the participants in the market. Consumers should decide how much they value their own health, and generous individuals can and will help who need long-term medical care.

Government intervention in healthcare leads to at least three detrimental outcomes:

  • Higher costs—paid by tax payers.
  • Misallocation of resources—robbing more productive people.
  • A general drag on the economy—costing the healthy and sick alike.

Will legislators ever have the political courage to take the right and effective action and get government entirely out of the business of providing healthcare?

 

Nations Cannot Win or Lose Trade Wars

Nation-states have no resources of their own. They redistribute the resources of their citizens. Nation-states can neither win nor lose when they play with other people’s resources. Tariffs and other weapons of trade wars disrupt normal trade; helping one group at the expense of another.

Illusion of Trade Deficits

The concept of trade wars begins with the illusion of trade deficits. When looking at the economy as a whole, trade deficits simply cannot exist. An economy, as a single unit, does not exist. An economy consists as a network of individual transactions. Thus, any comments about “an economy” require that we look at the nature of those individual transactions.

When a consumer acquires any good or service, by voluntary means, he always gives something in exchange — something he values less than what he gets. Thus, because the parties to an exchange leave with more value than they enter, no deficit can exist in any individual transaction. To make an hypothetical accumulation of all consumer transactions in an economic system the same logic must apply.

Buyers will always give money for the products they buy, whether from a local supplier or from a supplier in another country. Consequently, no deficit exists.

What Happens to the Money?

If a buyer always pays money for goods that he receives from overseas, what happens to that money?

One of three different things can happen to that money:

  • That money pays for products from the country of origin. Those purchases count as exports from the country of origin and thereby reduce the trade “deficit.”
  • That money acquires investments in the country of origin. Those investments, although not included in the GDP, have future benefit for that country.
  • That money buys government debt, which provides money for government giveaways. Those giveaways add to consumption and thereby the GDP. Not a bad thing from the policy-makers’ perspective.

How Do Tariffs Help Nation States Win War?

Only nation-states engage in “trade wars.” Peaceful traders have no incentive to engage in unhealthy activities.

The people involved in actual exchange do so voluntarily and peacefully. If they don’t like the terms of the exchange, they either renegotiate or abandon the transaction.

Since nation-states have no resources of their own, their actions — either through trade restrictions or tariffs — simply redistribute the resources of their own citizens. Nation-states have no weapons of their own for the conduct of trade wars; thus, they have no way of either winning or losing.

Trade Wars Cause Economic Disruption

The trade wars between nation-states disrupt the economies that they profess to help. In an effort to assist one part of the economy they always cause disruptions in other parts of the economy. The policies used in “trade wars” ignore the complexity of the markets with which they deal. For every player their policies help, multiple parties get hurt.

A couple of diagrams will give a very simple idea of the disruption caused by trade wars using tariffs.

Before Tariffs

This first diagram shows the situation before the implementation of tariffs. The consumer buys good G from supplier F (a foreign supplier) instead of buying the same good from supplier A (an American supplier) because it costs less money.

With the money the consumer saves he can buy products from other suppliers. The money earned by those other suppliers can, in turn, buy additional goods from an undetermined number of other suppliers (depicted by the cloud at the bottom).

The consumer gets more benefit and part of that benefit gets passed on to the rest of the economy.

After Tariffs

After the imposition of a tariff, which makes the price of good G from supplier F higher than the price from supplier A, the consumer will have to pay a higher price for the same product. This causes a chain reaction of negative results.

The consumer no longer has the extra money saved. He reduces his spending with other suppliers. The revenue of these other suppliers declines, and they spend less money with their suppliers. An indeterminate number of people in the economy get hurt as a result of the imposition of tariffs.

Please keep in mind the extreme complexity of international trade. A small intervention at one point in the trade process will have effects that ripple throughout the national economy and the international economy. We have no way of measuring the effect of these interventions. Because they always cause a disruption the normal trade process, these interventions will always have negative consequences.

Conclusion

Nation-states can gain only one thing by engaging in trade wars: political power. Some politicians think they are doing good things for their constituents by engaging in trade restrictions and tariffs. They base the activities of “trade war” on the false premise that trade deficits actually exist and they must be cured.

International markets, just like to domestic markets, are entirely too complex to be effectively managed. Messing with otherwise free markets only causes damage to the participants. In particular, it causes damage to those the politicians have sworn to protect.

 

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.

Conflicting Value Theories

Since the beginning of economics as a specialized study, economist have realized that the concept of value lies at the core of economic theory. They have developed several value theories over the years but most of those theories have suffered from fatal flaws. The only theory that holds up to logical scrutiny is the Subjective Theory of Value. Before I address the Subjective Theory of Value I would like to mention some of the primary value theories that have been advocated over the years:

Intrinsic Value Theory

The idea that goods have intrinsic value— value contained within the good — seems rather appealing on the surface, but it runs into some severe logical problems. Does a hammer have the same value when being used as a paperweight as it does when it’s being used to pound nails? Intrinsic Value Theory would say the hammer always has the same value. But does that really make sense?

Despite its fundamental flaws the idea of intrinsic value lies at the heart of many other value theories.

The Labor Theory of Value

The Labor Theory of Value — associated primarily with Karl Marx — advocates that an economic good has value based on the amount of labor required to create it. Again, this sounds appealing. But, do identical cabinets have different values if one cabinetmaker takes twice as long to create his cabinet?

This theory obviously relies on the belief that labor has some sort of intrinsic value. Based on that premise one could argue, for example, that all workers should receive the same pay.

Marx had some clever ways to get around the handicaps of this theory. In the process of attempting to reconcile these handicaps he made this theory more inconsistent.

The Cost of Production Theory

The Cost of Production Theory tends to develop a circular pattern. If, for example, the value of a good offered to a consumer depends on the accumulated costs involved in its production, from where do those costs originate? This assumption leads back to the question about intrinsic value. Goods somewhere in the higher levels of the production structure must have an intrinsic value. Without that assumption no justification exists for costs at lower levels.

Where then do the original factors of production — land and labor — acquire their value?

Exchange Theory of Value

The Exchange Theory of Value argues that economic goods produced or held for the purpose of exchange have an exchange value separate from their utility value — or their usefulness to a consumer.

But why should the same economic good have two separate value attributes? If someone owns a chainsaw for the purposes of cutting wood, does that chainsaw’s value suddenly change when they exchange it for a Cadillac?

The exchange theory implies that any economic good has competing values based on what the owner intends to do with them. This idea makes it a rather inconvenient theory at best.

And, how do you measure a good’s value?

Monetary Theory of Value

The Monetary Theory of Value argues that value appears only in the form of monetary prices. This argument, however, has one fatal flaw.

The value of one economic good cannot be measured in terms of the quantity of another economic good (i.e. a money commodity) accepted for it in exchange. The measurement of anything, to be logically consistent, must share a common unit at any place or time. A mile represents the same distance anywhere on the earth. A pound weighs the same anywhere on the earth. A dollar, on the other hand, does not have the same value at all times and in all locations.

I have elaborated earlier on why money cannot act as a measure of value.

Power Theory of Value

The Power Theory of Value incorporates the influence of politics into market exchanges. Market prices, therefore, derive not from utility but from the relative power of the parties involved in the exchange. The ownership of capital represents the primary source of power.

We will see in our discussion of the Subjective Theory of Value that most value theories have the market power structure inverted. Power emanates from the consumer and not from the producer.

Subjective Theory of Value

The elegance of the Subjective Theory of Value lies in its 1) simplicity and 2) ubiquity.

  1. Economic value has only one source: the subjective judgments of individuals.
  2. This source applies to all economic goods in all situations at all levels of production.

The subjective theory provides the only consistent “measure” of value in any place at any time. That measure consists of the relative preferences of the individual judging the value. In the mind of any individual one economic good always has relatively more or less value than any other economic good.

No objective measure exists for economic value. It is only in the process of exchange, in the revealing of price, that any hint of that relative value becomes exposed.

Summary

I have provided only brief explanations for some of the more popular theories of value. If you want to understand them thoroughly, you can research these theories on your own.

Only the Subjective Theory of Value holds up to logical scrutiny. I will discuss this theory in greater detail in my next post.

 

Introduction to Exchange

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

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.