The Price Is Right
In the long-running American television game show “The Price Is Right,” contestants compete in trying to get the price of displayed goods “right.” Whoever gets closest to the real price of the good wins the round. The idea is simple enough, since we’re all used to seeing prices presented to us printed on price tags in stores. The prices are non-negotiable, so we either pay the price or don’t get the good. Simple enough. So all the contestants in the game show need to do is guess what is on the price tag. But where does that price come from? And what’s to say that this price is “right”? Prices can be different in different stores, and they can vary over time because of inflation, competition, and temporary sales. So which price does the game show use? Perhaps they would say that they use something resembling the “market price” for the good, but this only raises the question: where do market prices come from?
There is something missing to our story. It is not at all obvious how we get to a world where we are presented fixed prices for a multitude goods in stores from the what we discussed in the previous chapter: the simple opportunities for exchange of goods for mutual benefit because we value things differently. If the reader recalls, we actually touched briefly on prices in chapter 1 – but only as something guiding production choices, and arising as a result of entrepreneurs bidding for resources to use in production of goods and services. Those are not the prices we see in stores, however, which are exclusively for goods intended for consumers. So how do we get to the point where goods in stores have prices, and what is to say that those are the right prices?
The answer is that there is no such thing as a “right” price. We could also say, which is equally accurate, that all prices are right. The reason for this is that goods and services offered for sale in the market do not have a single price, but have many. This is easy to understand if we return to the discussion in chapter 1 where individuals exchange goods. In any single exchange, each good has two prices: one for the buyer and one for the seller. For instance, if Adam offers Adele a can of coke in exchange for an apple, then we know two things about the valuation of these goods: we know that Adam values the apple more highly than the coke, and, assuming Adele accepts the terms, that Adele values the coke more highly than the apple. In this case, they’re both willing to go through with the exchange since both expect to be better off – subjectively speaking, that is by their own ranking of preferences – with what the other party offers. But it is wrong to conclude from this that the apple “is worth” a can of coke. It is for Adam, since he’s willing to give up a coke for the apple. But it isn’t for Adele, who rather makes the opposite exchange.
Unfortunately, this doesn’t get us to a point where there is a price of the goods exchanged. The reason is that for Adam to offer his can of coke for the apple, all we know is that he values the apple more highly – but we don’t know how much more highly. We also know that Adele is willing to give up her apple for the can of coke, which means that she values the coke more highly than the apple. Neither means that the price of the apple is a can of coke. To say that this is the case is to claim that they are valued the same, which means a person would be indifferent to which of the two he or she acquires – and this is not the case for either Adam or Adele. So since they’re both willing to go through with the exchange, they must both have different “prices” in mind where they would be indifferent to going through with the exchange. Perhaps Adam thinks the apple is worth two cans of coke while the coke to Adele is worth an apple and a half. We don’t know, but we do know that they value the goods differently and therefore have different prices for them.
The same reasoning applies if Adam, instead of negotiating with Adele, would drive to the grocery store to buy an apple for money. However he values his money, in order for him to go through with the exchange – that is, to buy the apple – he must think the apple is “worth” more than the money he gives up to buy it (including the time and effort and gasoline it takes for him to get to the grocery store and back). If the money is worth more than the apple, then he would be worse off buying it. So he won’t. If they are worth exactly the same to him, then going through with the exchange means nothing to him – it is a pointless and worthless endeavor.
Indeed, the same goes for the store owner, who wouldn’t sell the apples if they were worth more than the money offered in exchange for them. But this isn’t obvious when considering large companies such as WalMart, and there is more to discuss about prices before we get to the price printed on the thousands of price tags on goods stacked on numerous shelves in myriad aisles in a WalMart Supermarket. At this point, it is sufficient to point out that this requires no alternative logic. The same logic holds as for Adam and Adele, but it requires more elaboration to see it.
The supermarket example introduces a phenomenon that is not present in the example of Adam and Adele: money. We tend to think of money as value, but this is a shorthand and not entirely accurate. A dollar bill has little use value except for the fact that you believe that others will accept it in exchange. Were this not the case, it would really just be a piece of paper with ink all over it. In fact, it would probably be more valuable had it not had all that ink all over it, since then it could at least serve as paper for taking notes!
As generally recognized by economists, money is a universally accepted medium of exchange. In other words, money is useful – that is, we consider it valuable – because we know that we can offer it as payment for goods that more directly satisfy our wants. We know that others will accept money as payment, and that’s the whole reason money is valuable. Money, we could say, has value for the simple reason that others accept it as payment, even though dollar bills cannot be used for much else. So money have value for its indirect usage. Now we can see how money could be explained using the simple example of exchange that we discussed in chapter 1. We noted that in the simple exchange situation people have an incentive to produce things of value, which can then be offered in exchange for what is more desirable. Indeed, the best good to produce would be one that others value highly – especially if many or all value it – so that it increases the chances to find someone who wants it in exchange. So the most valuable type of production undertaking is not necessarily to produce what you want yourself, but produce something others really want and that you’re good at producing. This way, you maximize your chances of getting as much as possible of the goods and services that you value.
In other words, production is undertaken to increase one’s own well-being, that is in self-interest, but what is produced is produced to satisfy the wants of others. This is what entrepreneurs do, as was pointed out in chapter 1. They produce not what they wish to personally consume, but produce what they are good at producing and believe others will want – and value highly – so that the entrepreneurs can then use the produced good as a means to get what they really want through exchange. It might seem a bit roundabout or indirect, but it makes sense since we all have different skills and abilities and we tend to get better at producing if we specialize and focus on one type of activity. So to get as much as possible out of our efforts, we want to play on our strengths and produce what we’re relatively good at producing rather than producing what we actually need but lack skillset to produce.
By doing this, we soon get to a point where we are all producing for each other and maximize our own well-being by satisfying other people’s needs. So by serving others, we serve ourselves. This is what Adam Smith called the “invisible hand” of the market. It is a fairly simple and intuitive but still powerful concept, but one that is often misunderstood or even forgotten.
Out of this situation where people are busy producing for each other – for the market, as it were – it is easy to see that some produced goods are more usable than others to trade. They may be valued by more people, for instance. But they could also be relatively easy to store and to transport, have long shelf life (that is, they don’t go bad quickly), and so on. It would then make sense for people to offer their own produced goods for sale with payment in these more easily usable goods rather than directly engage in exchange for what they need personally. For instance, if Adele grows apples for a living, which means she has a lot more apples than the one she offers to Adam, then she would like to use as many apples as possible in exchange before they go bad. She has no use for hundreds of apples, but there may be hundreds of people who want an apple or two each. One possible solution to this conundrum is for Adele to find the people who have something she wants and who want apples, and then offer to trade. But it is much easier to find people who want apples but offer something that fits the description of money: something that a lot of people want and that is easy to store and transport, and so on. Adele would be willing to trade for those things, since she can use them later. Apples, as we know, is a seasonal good, so Adele is stuck every fall with hundreds of apples and has none for the rest of the year. So she needs to make sure she gets whatever she can for them in exchange, and that she acquires something that retains value and doesn’t go bad.
This way, some goods emerge as much more universally usable than others. And as people keep exchanging for certain goods in order to use them in future trades, they become a standard. Whether it is sea shells, cattle or gold coins, what matters is that others accept them as payment in exchange for their goods, not that you want those things yourself. This is how a money is born, or at least how we can conceive of money being born, according to Carl Menger. By just allowing people to exchange to satisfy their own wants, and to produce in order to further their position, we get to a money economy.
The Determination of Prices
As soon as we have money there is a common unit in the market in which prices can be expressed. This doesn’t really change anything with respect to where prices come from or how they are determined, but money makes it easier to express, communicate, and compare prices. It is, after all, a lot easier to figure out one’s options with information such as “a dozen apples trade at two gold coins and loaves of bread at one gold coin each” than “an apple was exchanged for a can of coke and a loaf of bread was exchanged for a dozen three-inch nails.” And it is easy to see how the former offers many more options, since only two trades are necessary to purchase any good. In contrast, with the price information just given for a non-money economy, Adele would have to find the people with matching wants for each of a potentially long series exchanges in order to get what she wants (unless she can find someone willing to exchange a loaf of bread for apples). For instance, in order to buy a loaf of bread she might have to first sell an apple to Adam for a can of coke, then find someone to trade the can of coke for a dozen nails, and then visit the baker to offer the nails for the loaf. That is, assuming the baker wants more nails than the dozen we know that he already accepted. And, of course, it might be the case that Adele has to sell two apples for two cans of coke, for which she can get twenty nails, of which twelve can be used to buy the bread. But what if she doesn’t want the remaining eight nails?
With money as a universally accepted medium of exchange, more trades become possible and each exchange is less costly because there is no need for finding someone who has what you want and wants what you have – what we call “coincidence of wants.” Recalling what we learned in chapter 1 about voluntary exchange, more trades means more value is created since through every undertaken exchange all involved parties are better off (or they wouldn’t do it). Consequently, more value is created faster in a money economy than in a barter economy.
With money, Adam and Adele no longer have to exchange the can of coke for the apple (though they could, of course, if they wanted to). Instead, if Adam has already traded with others for money he could offer Adele a money price for the apple and save the coke to enjoy with the apple. Money might be just as good for Adele as the coke, or even better if she’s a diabetic or doesn’t like the sweet taste of soda pop. The nature of the exchange between Adam and Adele doesn’t change because money enters the picture, however. It will possibly be easier for bystanders to recognize the price paid for the apple, but the logic is exactly the same: Adam will value what he gives up in the exchange less than what he receives, and Adele will value what she gives up less than what she receives. But with money it is perhaps easier to see why Adam and Adele value things differently. They will have different personal preferences and tastes, but they are also in different positions: Adele, as a grower of apples, wants to exchange apples for something she can use as payment to acquire goods and services when apples are not in season; Adam’s occupation as maker of coke is irrelevant for this exchange, as what he offers in exchange for the apple is simply money. So Adam and Adele only need to have one thing in common: their recognition (or belief) that money is a medium of exchange and therefore will buy other things from other people, which also means they will be able to judge whether the price asked by Adele is reasonable considering the purchasing power of money (how much of other goods can be bought for this money). They may also, for the sake of this transaction, be unknown to each other – perhaps completely anonymous – since what matters is the apple offered for sale and the money offered as payment. Without money, however, Adam and Adele had to establish their coincidence of wants and figure out whether Adam’s can of coke was really sufficient payment for Adele’s apple, and vice versa.
What is the price of the apple, then? As measured in the unit of account – money – we can observe exactly what Adam pays Adele. With what we know about exchanges, we know that this payment is valued more by Adele than the apple, but we don’t know how much lower she is willing to go. We also know what Adam was willing to give up in terms of money for the apple, and that he values that amount of money less than the apple.
Say that Adam offered ten moneys for the apple and that this was plenty for Adele so she was glad to accept the offer. This means the price for that apple is ten moneys. Whether this is reasonable or not is impossible to know at this point. But assume Bart is a baker and that he’s recently sold a loaf of bread to Becky the nail smith for eight moneys and that Becky sold a dozen nails to Charles for fifteen moneys. Now we have prices of several goods and can compare the revealed money prices to our preference rankings of those goods. We now know that others have traded a dozen nails at a higher money price than the loaf of bread and that the loaf of bread, in turn, traded at lower than Adele’s apple. We should also know how much money we have accumulated by selling whatever it is we produce, and therefore how we subjectively value that money – both in terms of the toil and trouble of producing those goods and the purchasing power of the money on hand. Similarly, Adele probably based her decision to sell the apple for ten moneys to Adam on her knowledge of how much bread or nails she can purchase for that money. Adam, in turn, based his decision to pay ten moneys for the apple on what he knew about the purchasing power of money and his subjective valuation of those other goods he could have bought.
So with a medium of exchange everybody is able to figure out the relative value of money in exchange for goods and thereby decide what particular exchanges to pursue, and in what order, to maximize utility. As everybody is engaged in deciding what and how much to buy of each good, a “social” relative valuation emerges. The process is the same as we saw above with the entrepreneurs bidding for resources – an issue we will soon get back to – and has the same result. Depending on the anticipated price situation, each person decides how much to produce: Adam decides how many cans of coke to produce, Adele decides whether to expand or cut down on her orchard, Bart makes up his mind about how many hours he wants to spend by the oven, Becky in the forge, and so on. Their decisions are based on how much money they expect to be offered for their produced goods, and – more importantly – how much of other goods those moneys will buy in return. In other words, they consider the tradeoff using the purchasing power of the moneys they anticipate that their products will buy. With money, it is easier to consider one’s true opportunity cost and therefore to decide on production, consumption, and the value of time.
The price thus goes both ways. Considering the particular exchanges mentioned above, an apple was traded for ten moneys, and vice versa; a loaf of bread was traded for eight moneys, and vice versa; and a dozen three-inch nails were traded for fifteen moneys, and vice versa. Because we have prices of all goods (except the money) in a common unit – money – we can compare their prices: we know, for instance, that a dozen nails are almost double as expensive, in moneys, as bread. If we had not had any money prices, we could not use anything but our own preference about each good to rank them in terms of value. Thanks to the money prices we can estimate their market value and consequently plan our actions better.
Money also opens up for bidding such that Adam, Bart, Becky, and Charles can all offer to buy Adele’s apple(s). Before money was introduced, they would all have to – assuming her exchange with Adam was an expression of exclusive preference – go through intermediate exchanges in order to get cans of coke to offer Adele in payment. Now, however, they do not need to pursue specific chains of exchanges to get something Adele prefers, but can simply offer their products in the market for money – and then use that money as offered payment for Adele’s apple. This means that Adele’s potential customer base has expanded drastically; anyone in this little society would now, in principle, be able to offer payment for apples. In other words, customers would be able to bid for apples. As Adam offers ten moneys for an apple, Becky could offer eleven and Bart twelve. The same goes for all other products, so perhaps Bart offers fifteen moneys for a dozen of Becky’s nails whereas Adam offers sixteen and Charles, who values nails most highly, offers the highest price of eighteen moneys.
This type of bidding to buy products forces buyers to offer as much as they can for each product in order to buy the products. While they wouldn’t go higher than they think is worth it, which means they will always offer prices in money that they value lower than the product they aim to purchase, they would probably offer higher prices than they otherwise would have. They are still better off, but not as well off as they would have been had they been the only customer. What this means, from a societal point of view, is not a loss but a gain: the person who values a good most highly, in terms of his or her subjective valuation of money, will come out on top in each bidding. The realized value of each good, therefore, is the highest possible.
How so? Let us consider as example the bidding for nails above, where Bart offers fifteen, Adam sixteen, and Charles eighteen for Becky’s dozen nails. The only thing this tells us is that Bart values the nails more than fifteen, Adam more than sixteen, and Charles more than eighteen. If none of them are willing to go higher and Charles therefore wins the bidding, we know a little more. We know that Bart values sixteen moneys more highly than the dozen nails and therefore that he values the dozen nails somewhere between the fifteen moneys he offered and the sixteen moneys he didn’t offer. The same goes for Adam, who offered sixteen moneys and therefore values the dozen nails higher but not as highly as the eighteen moneys he would need to bid in order to match Charles’ bid. So Adam values the dozen nails at between sixteen and eighteen moneys. Only Charles values the dozen nails higher than eighteen of his moneys, so he is the one who values them most highly (in moneys).
This doesn’t mean, of course that Charles has the objectively highest valuation of (that is, the greatest need for) the nails, only that he subjectively values them most highly in terms of money. This is not completely arbitrary, however, since his valuation of money is based on the purchasing power of money, and therefore how he values all other goods available in the market as well as his own time and labor that goes into earning the moneys he spends. It’s an approximation of valuation, but as close as we can get.
If we also have several sellers so that Adele is not a monopolist but has to compete with Agnes and Anton, who also have invested in orchards to sell apples, to sell to the customers, then they will bid prices down for the chance of selling their apples. The result is an established “price” that, because it incorporates all of the involved individuals’ valuations at that moment, reflects the joint subjective valuation of apples with respect to the subjective valuation of money – for both buyers and sellers. It means that, in equilibrium, no apple buyer who values the apples higher than the final price is left without and no apple seller who values the final price higher than the apples is left with apples. This is the determined market equilibrium price, which is a “maximizing” price from the point of view of social value. At this price, the market clears; there are no more gains from trade possible.
This is nothing new, but is actually the standard supply-and-demand diagram taught in Econ 101 classes in college. But it is important to understand the dynamic that precedes and is only implicit to the snapshot shown in the diagram, and that it is based on the many subjective valuations and the consequent actions taken by people who have some form of interest in the products exchanged: in this case, apples and money. The situation we ended up with is one where all involved get as much as possible – that is, they maximize their utility. Why? For the simple reason that whoever values the money necessary to buy an apple more than the apple will keep their moneys, and whoever values an apple more than the money necessary to buy it is able to buy an apple.
This “equilibrium” situation doesn’t mean everybody in this economy is fully content with what they have, of course. There may be many who really want to buy an apple or two but who value the money necessary to buy it more than the apple. Or to put this differently: they would really like the sweet taste of a newly picked apple had the price been lower. What this means is that their opportunity cost for buying an apple exceeds that of not buying it. So they are – based on their own, subjective valuation – better off not buying it, no matter how good they think the apples taste. If it were any other way, they would be willing to give up more for an apple. And if the reason they “can’t” buy an apple is that they don’t have enough moneys, they should be willing to work harder or longer hours or doing other things (and perhaps not buy other things with the money) in order to accumulate the moneys needed. In our limited example, there is nothing keeping them from producing and exchange the goods for money to then use for the purchase of apples. So the reason they don’t have the money now, when they want to taste an apple, is that they made another decision previously: they either valued leisure more highly than labor, which is why they couldn’t accumulate the funds necessary, or they labored enough but spent the money earned on buying other goods that they, at that point, considered more valuable to them than apples. There are other concerns as well, especially if we compare this model with the real economy that we live and work in, but we will touch on those issue in a later chapter.
Menger C. 1892. On the Origin of Money. The Economic Journal 2(6): 239-255.
Smith A. 1776. An Inquiry into the Nature and Causes of the Wealth of Nations.
 (Smith, 1776)
 (Menger, 1892)