The Meaning of Price III

By M. Northrup Buechner

Another in a series of essays elaborating Objective Economics: How Ayn Rand’s Philosophy Changes Everything about Economics by the author.

Back from hurricane Sandy, I apologize for the long delay between parts II and III on the meaning of price.

My last blog ended with a challenge for the reader. What was wrong with the following argument (made in favor of controls on gasoline prices in the 1970s)? Over the period of the controls, the price of gasoline rose over four percent a year while sales of gasoline rose at the same time. The law of demand says that when the price goes up, the quantity goes down, but that was not true of gasoline over this period. Therefore, gasoline is an exception to the law of demand. If we remove the controls, the oil companies will raise the price of gasoline,  but the quantity will not fall. Instead, the oil companies will make huge profits while the shortages and lines continue.

The fundamental error in this argument is the assumption that the state owns the economy and can morally do anything it wants with the property of its citizens. Nothing can justify this idea. It is not only false, but evil, and that is all that is necessary to invalidate the use of wage and price controls on an economy.

However, there is another issue at stake here—a pure economic issue—the doctrine of relative prices. This doctrine says that the meaning of any individual price depends on its relation to other prices. No price stands alone. In fact, a price that does stand alone is meaningless.

An example of a price standing alone is 50,000 toskas for a pair of shoes in Quasiland. Since 50,000 toskas has no relation to any other price, it has no content in your mind. You do not know what it means. You do not know whether shoes in Quasiland are cheap or expensive, a product routinely given away or a product only the very rich can afford. Compare this to 200 dollars for a pair of shoes in New York City. Now the price is fully meaningful to you; you know exactly what it means, but that is because it does not stand alone. (More on this to come.)

Now let us see what the doctrine of relative prices has to do with the statist argument against removing price controls. The salient fact was this: during the s that the price of gasoline was rising four percent a year, the annual increase in the consumer price index (CPI) was averaging over seven percent. This means that relative to prices in general, the price of gasoline had been falling, and the rising gasoline sales over this period were absolutely consistent with the law of demand.

This is the significance of the doctrine of relative prices: every price exists in a network of other prices. Each price gets its meaning from its relation to this network. Prices are high and low, increase and decrease, only in relation to other prices. If a price increases less than the average increase in price, that is a fall in relative price, with the economic consequences of a fall in price (as we have just seen in the case of gasoline). If a price increases more than the average increase in price, that is an increase in relative price with the economic consequences of an increase in price.

An economy in which the average price increases over time is an economy afflicted with price inflation, and prices increase or decrease only relative to the average increase in all prices. The American economy has had price inflation since the mid-1930s.

Next time, we will see the use economists make of the doctrine of relative prices, and where they go wrong in its application.