This is part four of my summary of Murray Rothbard’s Man, Economy and State. You can read part three here.
In the previous part, I mentioned the advantages of having a common money that everyone uses for exchanges. One of the advantages is that it becomes easier, for a business, for example, to tell how much they have gained or lost. Without a common money, it would be harder for them to know whether they are making a profit. If instead of acquiring money for their services, the business was being paid in televisions, mattresses, and shoes, it would be hard for them to know exactly how much they have gained in exchange for their services, since in order to find that out, they would have to somehow figure out what they would be able to exchange the televisions and shoes for.
If we had no common money, the value of a good would have infinite prices, since the value of it would be represented by the different things that you could exchange the good for. The price of a television would be 10 shoes, or 30 gallons of milk, or 20 t-shirts, etc. Having one common money allows you to easily determine the value of something, since you only have to compare the good to one other good (money), instead of to all the goods available in the economy.
How Prices are Determined
How is the price of a good determined? This goes back to the very important concept of Scale of Values. I mentioned in earlier parts that each person has a scale of values that determines what is important to the individual. This scale basically allows us to compare multiple goods, and see if good A is more important than good B, to the individual. So, since money is just another good, money also belongs on the scale of values. If an individual had the scale of values shown below, the most this individual would pay for a television would be two hundred dollars.
What the scale of values above means, is that to this individual, the television is worth more to him than two hundred dollars, which is the only reason he would be willing to give up two hundred dollars to obtain the television. However, two hundred and one dollars is worth more to him than a television, so this individual would not be willing to purchase the TV at that price. Remember that individuals act so they can end up in a better situation than they previously were. If an individual doesn’t think he is better off by making the purchase, the exchange will not occur.
In this case, if the seller wanted to sell his TV, he would have to offer it at a price of $200 or less. But remember that the seller is also an individual with his own scale of values. For the seller to be willing to sell his TV for $200, his scale of values would look like this, for example:
To the seller, $200 is worth more to him than the television, so he is willing to sell it at the price that the buyer is willing to buy it at. In this scenario the exchange can occur, since both the buyer and seller feel they will be better off than they were before the sale, since each one values what he is getting more than what he is giving up.
The price of a good is determined by the demand schedule of the buyers in the economy, and the supply schedule of the sellers in the economy. The demand and supply schedules are determined by the scale of values of each individual.
But what determines how high or low, a good will be in an individual’s scale of values? What determines how valuable something is to an individual? This goes back to the other very important concept of Marginal Utility. I mentioned before that the marginal value of a product is the value that an individual places on an additional unit of the product. If you already have a lot of something, you won’t be willing to pay a lot for yet another unit of the product. Also, the price a buyer is willing to buy something for depends on the marginal value of the money he would be giving up. If the buyer doesn’t have a lot of money, he might be unwilling to lose an additional $10. The buyer will compare the marginal value of the unit he is gaining versus the marginal value of the money he is giving up.
In summary, prices depend on the demand and supply schedules for the goods, which depend on individual demand and supply schedules for that good, which depend on the scale of values of the individuals, which depend on the value the individuals place on additional units of the good (the marginal value), and the marginal value of the money they are either gaining, or giving up in the trade.
The marginal utility of money today depends on what its goods price was yesterday since you need to know what you can get with that money to determine where on your scale of values the money will go.
Some Economists have a hard time explaining how the marginal utility of money can always depend on its marginal utility the day before. We must reach a point where the marginal utility of money did not depend on the marginal utility of it the day before, in order for it to make sense. There must be a beginning.
To answer this, we must go all the way back to when the money first started being used as a medium of exchange. At first, when the economy was based on barter, the marginal utility of goods didn’t have to depend on anything. You simply compared the product you were giving up to the product you were gaining in the trade. Then later, a good, like gold, started being traded not for its direct uses, but in order to be used in future trades.
For individuals to place a marginal value on money, they must know all of the possible things they will be able to trade that money for, in the future. The marginal value today, then, must depend on all the things that that amount of money was able to be traded for, yesterday. This goes all the way back until the time when the money itself was traded for its direct benefit, meaning when the medium of exchange (e.g., gold) was compared with each and every product in a trade. So the marginal value of the medium of exchange was once compared directly with all of the products in trades that involved that medium of exchange, when it was just a product, and not a medium of exchange. This is the beginning we wondered about.
Interrelation of Goods
The demand for a good is said to be elastic if an increase in its price results in a decrease in the quantity demanded. The price changes of inelastic goods, on the other hand, have relatively little effect on the quantity demanded.
So far we have discussed how the prices of goods come about, based on the scale of values of each individual. What we have yet to discuss is how a change in the price of one good could affect the price of other goods.
Two goods can either be complementary or substitutes. Complementary goods are goods that are usually used together (e.g., peanut butter and jelly). All goods are basically substitutable for one another, since money is scarce and we must choose what to spend our money on. When an individual decides he will not go away on vacation, choosing instead to use the money for a new car, you can say the car and the vacation are substitutable goods. Of course, some goods are more substitutable than others. Chicken and beef are closer substitutes.
Depending on this relationship, a change in the price of one good–caused by a change in either the supply or demand of the good–will affect the price of other goods. Whether the other goods are considered substitutes or complementary and whether the change in price occurred as a result of a change in the supply or demand, will determine the direction the price of the affected goods will go.
If goods A and B are complementary, and the price of A rises due to a lowering of its supply, the demand for the complementary good B should fall which will cause its price to fall. Although not always the case, let’s pretend that peanut butter and jelly are always used together. If due to a shortage of peanut butter, the price of peanut butter rises, people will not only reduce their spending on peanut butter, but they will also reduce their spending on jelly, which will cause the price of jelly to drop. An important distinction is that the price of peanut butter was affected by a change in supply whereas the price of jelly was affected by a change in demand. The price of complementary goods go in the opposite direction when a change in supply occurs for one of the goods.
On the other hand, if the price of peanut butter goes up not because of a change in supply, but because people are demanding more of it, the price of its complementary good, jelly, will go up as well, since the people buy them as a package. The price of complementary goods go in the same direction when a change in demand occurs for one of the goods.
What about substitutable goods? If we consider chicken and beef to be close substitutes and the supply of chicken decreases, resulting in a price increase, what will happen to the price of beef? Well, it depends. If the demand for chicken is considered elastic, the price of beef will increase. This is because the higher price of chicken will cause people to switch to beef instead, which will eventually cause an increase in the price of beef, due to its higher demand. On the other hand, if the price of chicken were considered inelastic, people will still feel compelled to purchase the same quantity of chicken, which means they are now spending more money on chicken and will now have less money to spend on other things, especially beef, since it is a close substitute. This would cause the price of beef to decrease due to the fall in demand.
In summary, the price of substitutable goods go in the same direction if the change in the price of the first good is caused by a change in supply and that first good is elastic. They will go in the opposite direction if the first good is inelastic.
What about changes in the price of substitutable goods that are based on a change in demand? In this case, the price will always go in the opposite direction, regardless of the first good’s elasticity. If chicken’s price goes up because more people are demanding it, the price of beef will fall, because less people will be demanding it, due to it being a close substitute for chicken.
Remember though, that all goods are essentially substitutable for one another, since all goods compete for our money.
- Direct Exchange: Summary of “Man, Economy and State,” Chp. 2
- Fundamentals of Human Action: Summary of “Man, Economy and State,” Chp. 1
- Indirect Exchange: Summary of “Man, Economy and State,” Chp. 3