Who Actually Makes Money?

In an earlier post, I described a contradiction between popular economic theory and statistical data.

In this post, I will describe true premises upon which we can develop more accurate theories.

Popular Assumptions

Reserves held at the Federal Reserve somehow act as money — so goes popular assumption. When the Fed adds dollars to bank reserves, that simultaneously adds an equal number of dollars to the quantity of money. For a long time, empirical evidence seemed to confirm that theory.

Around 1973 evidence began to appear that contradicted this popular assumption. Since that time, the money supply has grown much more rapidly than have bank reserves.

In 2008 the assumed connection between bank reserves and the quantity of money completely broke down. The quantity of bank reserves skyrocketed while the money supply chugged along at about the same historical rate.

This contradiction exposed a critical question. Where did the error exist? — In the data? Or in the theory?

Flawed Premises

The error existed in the theory, for the theory started with a couple of false premises:

  • dollars = dollars
  • dollars always play the role of money

When a person selects one dollar bill over another from their wallet, they provide evidence that they do not value two, seemingly identical, dollars the same. People frequently confuse the idea of fungibility with that of equal value. Fungibility means that in a practical application, two nearly identical commodities can substitute for each other. On the other hand, no two individual commodities have equal value, for the simple fact that no two items are identical in all respects, and no individual will value them the same.

Every dollar is different from every other dollar. They have different serial numbers; some are new and crisp and others not; some dollars exist as Federal Reserve notes; some dollars exist as coins; some dollars even exist as negotiable checks. Thus, the idea that every dollar equals every other dollar either physically or in value proves false.

Every dollar does not play the role of money. The dollars with which you pay for your latte act as money. Any dollar you use in any exchange acts as money. Some dollars, however, do not act as money.

I once ate in a restaurant in which the walls were covered with dollar bills. People had written on those bills, laminated them, and hung them on the walls. These dollars did not act as money.

Dollars held in the accounts of banks at the Federal Reserve also do not act as money. For dollars to act as money, the public must be allowed to own and use those dollars for indirect exchange. The public cannot hold (or have a claim on) dollars held as bank reserves. We cannot, therefore, consider bank reserves as a form of money.

The Role of Bank Reserves

Bank reserves do not act as a form of money. They never have. When people use gold as a form of money, and banks had 100% reserves, banks would hold gold to back the claims represented by banknotes or checks. While held as reserves, gold no longer played the role of money. Only after the holders of banknotes and checks exercise their claim on gold (at which time the holders claim on the gold would be canceled), with the gold return to its former role as money. Gold and banknotes/checks would never play the role of money at the same time.

In the modern banking system, in which we have fractional reserve banking and reserves created by the Federal Reserve, this relationship has not changed. Bank reserves still do not play a role as money. They act more like a control mechanism on the ability of banks to create money.

In an hypothetical situation in which banks must hold a reserve equal to 50% of their deposit liabilities, a bank with $1,000 in reserves (2,000 reserve dollars) could create 2,000 money dollars (I use the phrase money dollars to distinguish them from dollars held as bank reserves). If the Federal Reserve created another thousand dollars in reserves, to pay for assets they acquired from the bank, the bank would have no obligation to create another 2,000 money dollars.

Historically, because of the relatively low level of bank reserves, when the Fed increased the quantity of reserves, banks would have sufficient demand for money that they would buy an adequate number of notes to fully use the capacity of their moneymaking capability. With the massive run-up in bank reserves at the time of the financial crisis in 2008, banks no longer had access to a sufficient number of quality notes for which to use their full moneymaking capacity.

Conclusion

The premise that the Federal Reserve adds directly to the money supply when it increases bank reserves contained flaws from the beginning. Bank reserves have never acted as a form of money.

When the Federal Reserve does increase the amount of bank reserves (under a fractional reserve banking system), banks have no obligation to use their full moneymaking capacity.

Thus, when we understand the distinction between dollars held as bank reserves (reserve dollars) and dollars held by the public for indirect exchange (money dollars), we have a more accurate premise from which to develop a theory about the relationship between bank reserves in the money supply. It makes perfectly good sense for bank reserves and the money supply to grow and contract at somewhat different rates.

 

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.

 

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.

Value Measure-Review

Because I will frequently return to the subject of value, and its measure, over the course of these blog posts I have decided to publish the text of the same article I posted May 16, 2016 (with some edits).

If individuals provide the only sources of value, how do those individuals measure value? Does every person have a standard unit of value to compare the economic value of one good to another?

In fact, value has no unit of measure. Unlike height, weight, volume, etc., people have no way to compare their values with those of other people — or, indeed, with the goods they value themselves. Value has no objective source; and value has no objective measure. Only the subjective preference scales of individuals provide a measure of economic value. An individual can only value one economic good more or less than another economic good. A person cannot quantify how much more, or less, he or she the values that good.

Example

Preferences
Hypothetical Preferences

A hypothetical example (see right) might prove useful. This list shows the preferences (listing the most preferred at the top) of one individual for some fruits in a selection at a specific time and place.

The order of these preferences might change in a different time or place. Also, this person cannot tell how much they prefer the peach to the pear.

Important Factors

I will touch briefly on several important factors about preference scales—like this example.

First, preference scales only exist in an instant. A person can prefer ice cream to cantaloupe in one moment and cantaloupe to ice cream in the next.

Second, the unit of measure (e.g. quantity, volume, length) of a good affects its place on the preference scale. A person might place a bowl of ice cream high and their preference scale but a gallon of ice cream relatively low.

Third, distance affects preferences. Goods nearby have more value than goods in the distance.

Fourth, time likewise affects preferences. A good in the present has more value than the same good in the future.

Fifth, each additional unit has less value than the previous unit — all at the same time and place in the same units. The second bowl of ice cream has less value than the first. The 100th bowl of ice cream has less value than the 99th, the second, and the first. Not after eaten, but in the moment when the individual decides to buy them.

Sixth, context — weather, hunger, social situations, etc. — has an effect on relative value. A cold man might place more value on an ugly coat than a warm man, who might prefer a more fashionable coat.

Other factors can affect value scales, but these are some important ones.

Summary

  • Individual preference scales provide the only measure of value.
  • Those preference scales have no units of measure; only ordinal ranking.
  • Preferences exist only at a point in time.
  • Many factors affect preference scales including space, time, units, and context.

In the next post I will address the relationship between value and price.

Value Source – Review

On May 11, 2016 I posted an article describing the source of economic value. I revisit that subject because of its vital importance to economic reasoning.

In this post I will respond to some questions which have arisen since I posted that article more than two years ago. I’m sure that these questions are not all-inclusive. Thus, I will address the source of value when it becomes pertinent to other topics on this blog.

Validation of Source

How do we know that individuals are the only source of value?

Of all the sources that have been proposed for economic value, only the individual as the sole source holds up to logical scrutiny. Every other source, whether it be intrinsic value, labor input, or production cost, require some modification when looked at in detail. The only element consistently involved in the determination of value consists of individual people.

Economic goods seem to have different values under different circumstances and different uses. This fact negates the validity of any intrinsic value.

The production of nearly identical economic goods can require vastly different degrees of labor in terms of time and quality. Thus, no consistency exists in the labor theory of value.

Different producers of nearly identical economic goods can have significantly different cost structures. The cost of production theory of value also fails logical tests.

On the other hand, the existence of value always involves individuals.

Use or Exchange

Is there a difference between use value and exchange value?

Some theorists have attempted to distinguish between “use value” and “exchange value.” From the standpoint of source these distinctions make no difference. From the standpoint of the individual “exchange” consists of just another form of use. This provides yet another consistency in advocating that individuals provide the only source of economic value.

Value of Money

Does money have a different source of value than other economic goods?

Some people have the mistaken impression that money has a different source of value than other economic goods. This could not be further from the truth, for money consists of just another economic good (or the claim for an economic good.) The only significant difference on this good is that it’s held for the purpose of indirect exchange. It has, however, exactly the same source of value as does any other economic good.

Conclusion

Having a logically consistent source of economic value plays a critically important role in the development of logically consistent economic theory.

The development of reliable theories in any field of study relies on consistent fundamental premises. The same applies to the source of value in the development of any reliable economic theory. The only consistently fundamental premise in the development of theories of value consists of individuals as the source of value.

I shall return to the importance of this fact many times in the course of my blog entries.