The Theory of Prices

The Theory of Value has traditionally been based on supply and demand, particularly in changes in:

• marginal cost and
• the elasticity of short-term 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.
• the elasticity of supply becomes zero
• demand becomes proportional to the quantity of money.

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.

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.

+++

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.

+++

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 depends:

• partly on the hourly-common-wage and
• partly on the volume of employment.

Changes in the quantity of money on the price-level are compounded of:

• the effect on the hourly-common-wage 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”.

These are the 5 possible complications which will 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.