The Theory of Prices Icon

January 5, 2020

The Theory of Value has traditionally been based on supply and demand, particularly in changes in marginal cost and the elasticity of short-period supply.

But when they pass to the Theory of Money and Prices, value becomes governed by

  • the quantity of money,
    • its income-velocity,
  • the velocity of circulation relative to the volume of transactions
    • hoarding,
    • forced saving,
    • inflation and deflation et hoc genus omne.

Little attempt is made to relate these vaguer phrases to our former notions of the elasticities of supply and demand.

The elasticity of supply must have become zero and demand proportional to the quantity of money. We get lost and do not know what route or journey connects them.

The foregoing chapters aimed to bring the theory of prices closer with the theory of value. It is wrong to divide Economics between=

  • the Theory of Value and Distribution
  • the Theory of Money

The right dichotomy is between=

  • the Theory of the Individual Firm* and its profits and money, and
  • the Theory of Output and Employment.

*Superphysics note= Keynes shifts economic power from the people to businesses

If we limit ourselves to the study of the individual industry or firm and assume that employment is constant and the conditions of other industries or firms are unchanged, then we ignore the significant characteristics of money.

But as soon as we look into output and employment as a whole, we need the complete theory of a Monetary Economy.

We could also divide:

  • the theory of stationary equilibrium and
  • the theory of shifting equilibrium

In this case, the theory looks at the changing views of the future as influencing the present.

Money’s importance comes from its being a link between the present and the future. Our concern for the future makes us consider how to distribute resources in equilibrium.

This view can be further divided between:

  • an economy which is unchanging and
  • an economy subject to change

Or we can pass from this simplified propaedeutic to the problems of the real world in which our previous expectations are liable to disappointment and expectations concerning the future affect what we do to-day. It is when we have made this transition that the peculiar properties of money as a link between the present and the future must enter into our calculations.

But, although the theory of shifting equilibrium must necessarily be pursued in terms of a monetary economy, it remains a theory of value and distribution and not a separate “theory of money”.

Money is a subtle device for linking the present to the future. We cannot even begin to discuss the effect of changing expectations on current activities except in monetary terms. We cannot get rid of money even by abolishing gold and silver and legal tender instruments.

So long as there exists any durable asset, it is capable of possessing monetary attributes[1] and, therefore, of giving rise to the characteristic problems of a monetary economy.

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In a single industry, its particular price-level depends partly on the rate of remuneration of the factors of production which enter into its marginal cost, and partly on the scale of output.

There is no reason to modify this conclusion when we pass to industry as a whole. The general price-level depends partly on the rate of remuneration of the factors of production which enter into marginal cost and partly on the scale of output as a whole, i.e. (taking equipment and technique as given) on the volume of employment. It is true that, when we pass to output as a whole, the costs of production in any industry partly depend on the output of other industries.

But the more significant change, of which we have to take account, is the effect of changes in demand both on costs and on volume. It is on the side of demand that we have to introduce quite new ideas when we are dealing with demand as a whole and no longer with the demand for a single product taken in isolation, with demand as a whole assumed to be unchanged.

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If we allow ourselves the simplification of assuming that the rates of remuneration of the different factors of production which enter into marginal cost all change in the same proportion, i.e. in the same proportion as the wage-unit, it follows that the general price-level (taking equipment and technique as given) depends partly on the wage-unit and partly on the volume of employment. Hence the effect of changes in the quantity of money on the price-level can be considered as being compounded of the effect on the wage-unit and the effect on employment.

Assuming

  1. All unemployed resources are homogeneous and interchangeable in their efficiency to produce what is wanted

  2. The factors of production entering into marginal cost are content with the same money-wage so long as there is a surplus of them unemployed.

In this case we have constant returns and a rigid wage-unit, so long as there is any unemployment. It follows that an increase in the quantity of money will have no effect whatever on prices, so long as there is any unemployment, and that employment will increase in exact proportion to any increase in effective demand brought about by the increase in the quantity of money; whilst as soon as full employment is reached, it will thenceforward be the wage-unit and prices which will increase in exact proportion to the increase in effective demand.

Thus if there is perfectly elastic supply so long as there is unemployment, and perfectly inelastic supply so soon as full employment is reached, and if effective demand changes in the same proportion as the quantity of money, the Quantity Theory of Money can be enunciated as follows= “So long as there is unemployment, employment will change in the same proportion as the quantity of money; and when there is full employment, prices will change in the same proportion as the quantity of money”.

Having, however, satisfied tradition by introducing a sufficient number of simplifying assumptions to enable us to enunciate a Quantity Theory of Money, let us now consider the possible complications which will in fact influence events:

  1. Effective demand will not change in exact proportion to the quantity of money.
  2. Since resources are not homogeneous, there will be diminishing, and not constant, returns as employment gradually increases.
  3. Since resources are not interchangeable, some commodities will reach a condition of inelastic supply whilst there are still unemployed resources available for the production of other commodities.
  4. The wage-unit will tend to rise, before full employment has been reached.
  5. The remunerations of the factors entering into marginal cost will not all change in the same proportion.

Thus, we must first consider the effect of changes in the quantity of money on the quantity of effective demand. The increase in effective demand will, generally speaking, spend itself partly in increasing the quantity of employment and partly in raising the level of prices.

Thus instead of constant prices in conditions of unemployment, and of prices rising in proportion to the quantity of money in conditions of full employment, we have in fact a condition of prices rising gradually as employment increases.

The Theory of Prices is the analysis of the relation between changes in the quantity of money and changes in the price-level with a view to determining the elasticity of prices in response to changes in the quantity of money, must, therefore, direct itself to the five complicating factors set forth above.

They are not independent. For example, the proportion, in which an increase in effective demand is divided in its effect between increasing output and raising prices, may affect the way in which the quantity of money is related to the quantity of effective demand.

Or, again, the differences in the proportions, in which the remunerations of different factors change, may influence the relation between the quantity of money and the quantity of effective demand.

The object of our analysis is, not to provide a machine, or method of blind manipulation, which will furnish an infallible answer, but to provide ourselves with an organised and orderly method of thinking out particular problems; and, after we have reached a provisional conclusion by isolating the complicating factors one by one, we then have to go back on ourselves and allow, as well as we can, for the probable interactions of the factors amongst themselves. This is the nature of economic thinking.

Any other way of applying our formal principles of thought (without which, however, we shall be lost in the wood) will lead us into error. It is a great fault of symbolic pseudo-mathematical methods of formalising a system of economic analysis, such as we shall set down in section vi of this chapter, that they expressly assume strict independence between the factors involved and lose all their cogency and authority if this hypothesis is disallowed.

Whereas, in ordinary discourse, where we are not blindly manipulating but know all the time what we are doing and what the words mean, we can keep “at the back of our heads” the necessary reserves and qualifications and the adjustments which we shall have to make later on, in a way in which we cannot keep complicated partial differentials “at the back” of several pages of algebra which assume that they all vanish. Too large a proportion of recent “mathematical” economics are mere concoctions, as imprecise as the initial assumptions they rest on, which allow the author to lose sight of the complexities and interdependencies of the real world in a maze of pretentious and unhelpful symbols.

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(i) Changes in the quantity of money primarily affect effective demand through its influence on the rate of interest.

If this were the only reaction, the quantitative effect could be derived from the three elements:

  1. The liquidity-preference curve which tells us by how much the rate of interest will have to fall in order that the new money may be absorbed by willing holders
  2. The marginal efficiencies curve which tells us by how much a given fall in the rate of interest will increase investment
  3. The investment multiplier which tells us by how much a given increase in investment will increase effective demand as a whole.

Those 3 elements abc are themselves partly dependent on the complicating factors (2), (3), (4) and (5).

The liquidity-preference curve depends on how much of the new money is absorbed into the income and industrial circulations.

This depends in turn on how much effective demand increases and how the increase is divided between

  • the rise of prices,
  • the rise of wages, and
  • the volume of output and employment.

The marginal efficiencies curve will partly depend on the effect which the circumstances attendant on the increase in the quantity of money have on expectations of the future monetary prospects.

The multiplier will be influenced by the way in which the new income resulting from the increased effective demand is distributed between different classes of consumers.

Nor, of course, is this list of possible interactions complete. Nevertheless, if we have all the facts before us, we shall have enough simultaneous equations to give us a determinate result. There will be a determinate amount of increase in the quantity of effective demand which, after taking everything into account, will correspond to, and be in equilibrium with, the increase in the quantity of money.

Moreover, it is only in highly exceptional circumstances that an increase in the quantity of money will be associated with a decrease in the quantity of effective demand.

The ratio between the quantity of effective demand and the quantity of money closely corresponds to what is often called the “income-velocity of money”; — except that effective demand corresponds to the income the expectation of which has set production moving, not to the actually realised income, and to gross, not net, income.

But the “income-velocity of money” is, in itself, merely a name which explains nothing. There is no reason to expect that it will be constant. For it depends, as the foregoing discussion has shown, on many complex and variable factors. The use of this term obscures, I think, the real character of the causation, and has led to nothing but confusion.

  1. Chapter 4 showed the distinction between diminishing and constant returns partly depends on whether workers are remunerated in strict proportion to their efficiency.

If so, we shall have constant labour-costs (in terms of the wage-unit) when employment increases. But if the wage of a given grade of labourers is uniform irrespective of the efficiency of the individuals, we shall have rising labour-costs, irrespective of the efficiency of the equipment. Moreover, if equipment is non-homogeneous and some part of it involves a greater prime cost per unit of output, we shall have increasing marginal prime costs over and above any increase due to increasing labour-costs.

Hence, in general, supply price will increase as output from a given equipment is increased. Thus increasing output will be associated with rising prices, apart from any change in the wage-unit.

  1. Under (2) we have been contemplating the possibility of supply being imperfectly elastic. If there is a perfect balance in the respective quantities of specialised unemployed resources, the point of full employment will be reached for all of them simultaneously.

But, in general, the demand for some services and commodities will reach a level beyond which their supply is, for the time being, perfectly inelastic, whilst in other directions there is still a substantial surplus of resources without employment. Thus as output increases, a series of “bottlenecks” will be successively reached, where the supply of particular commodities ceases to be elastic and their prices have to rise to whatever level is necessary to divert demand into other directions.

It is probable that the general level of prices will not rise very much as output increases, so long as there are available efficient unemployed resources of every type. But as soon as output has increased sufficiently to begin to reach the “bottlenecks”, there is likely to be a sharp rise in the prices of certain commodities.

Under this heading, however, as also under heading (2), the elasticity of supply partly depends on the elapse of time. If we assume a sufficient interval for the quantity of equipment itself to change, the elasticities of supply will be decidedly greater eventually.

Thus a moderate change in effective demand, coming on a situation where there is widespread unemployment, may spend itself very little in raising prices and mainly in increasing employment; whilst a larger change, which, being unforeseen, causes some temporary “bottle-necks” to be reached, will spend itself in raising prices, as distinct from employment, to a greater extent at first than subsequently.

  1. The wage-unit may tend to rise before full employment has been reached, requires little comment or explanation. Since each group of workers will gain, cet. par., by a rise in its own wages, there is naturally for all groups a pressure in this direction, which entrepreneurs will be more ready to meet when they are doing better business.

For this reason a proportion of any increase in effective demand is likely to be absorbed in satisfying the upward tendency of the wage-unit.

At full employment, money-wages have to rise due to an increasing effective demand in terms of money. This is proportional to inflation. Thus, we have a succession of earlier semi-critical points where an increasing effective demand raises money-wages though not fully proportional to inflation. This is the same in the case of a decreasing effective demand.

Actually, the wage-unit changes non-continuously in terms of money in response to every small change in effective demand. These points of discontinuity are determined by:

  • the psychology of the workers and
  • the policies of employers and trade unions.

In an open system, where they mean a change relatively to wage-costs elsewhere, and in a trade cycle, where even in a closed system they may mean a change relatively to expected wage-costs in the future, they can be of considerable practical significance.

These points, where a further increase in effective demand in terms of money is liable to cause a discontinuous rise in the wage-unit, might be deemed, from a certain point of view, to be positions of semi-inflation, having some analogy (though a very imperfect one) to the absolute inflation (cf. Section V below) which ensues on an increase in effective demand in circumstances of full employment. They have, moreover, a good deal of historical importance. But they do not readily lend themselves to theoretical generalisations.

  1. Our first simplification consisted in assuming that the remunerations of the various factors entering into marginal cost all change in the same proportion.

But in fact the rates of remuneration of different factors in terms of money will show varying degrees of rigidity and they may also have different elasticities of supply in response to changes in the money-rewards offered. If it were not for this, we could say that the price-level is compounded of two factors, the wage-unit and the quantity of employment.

Perhaps the most important element in marginal cost which is likely to change in a different proportion from the wage-unit, and also to fluctuate within much wider limits, is marginal user cost.

For marginal user cost may increase sharply when employment begins to improve, if (as will probably be the case) the increasing effective demand brings a rapid change in the prevailing expectation as to the date when the replacement of equipment will be necessary.

Whilst it is for many purposes a very useful first approximation to assume that the rewards of all the factors entering into marginal prime-cost change in the same proportion as the wage-unit, it might be better, perhaps, to take a weighted average of the rewards of the factors entering into marginal prime-cost, and call this the cost-unit.

The cost-unit, or, subject to the above approximation, the wage-unit, can thus be regarded as the essential standard of value; and the price-level, given the state of technique and equipment, will depend partly on the cost-unit and partly on the scale of output, increasing, where output increases, more than in proportion to any increase in the cost-unit, in accordance with the principle of diminishing returns in the short period. We have full employment when output has risen to a level at which the marginal return from a representative unit of the factors of production has fallen to the minimum figure at which a quantity of the factors sufficient to produce this output is available.

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