The Meaning of Price IV

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.

 

The doctrine of relative prices is both true and important. However, the use that economists and statisticians make of this doctrine turns on an invalid distinction—between the nominal price and the real price. Let us look at how this distinction is used.

The nominal price is the price in money, as we find it in stores and shops, a price such as $1.60 for a can of tomatoes. Nominal means in money terms, in the actual economy. Economists often call the nominal price, the absolute price. So far, this is valid.

The real price, on the other hand, is held to be the relative price. The real price is defined as the nominal price adjusted for the changing value of money, that is, adjusted for the general rate of price inflation. For example, suppose the rate of price inflation for the year 2013 is 100 percent (the average price doubles in the year). If the price of a can of tomatoes is $1.60 on January 1, 2013 and is still $1.60 a year later, the real price of the tomatoes has declined by half over the year, because on December 31, $1.60 is worth half of what it was worth on January 1. The real price of the can of tomatoes is half of what it was a year ago. But what is that price? How do we adjust $1.60 for the general rate of price inflation to get the relative price? The answer is that we don’t.

The meaning of “real price” is not about individual concrete prices, such as $1.60 for a can of tomatoes. The meaning of the real price (and the relative price) is limited to the statistics of price indices. Statisticians calculate an index for the general price level by averaging changes in the prices of thousands of different consumer goods and services over some time period. Percentage increases (or decreases) in this index, the consumer price index (CPI), are where we get the estimated rate of price inflation, regularly reported by the news media.

The same method is used to calculate price indices for narrower categories of goods and services such as a medical care, college tuition, and gasoline. Then the narrow indices are compared to the general price index. If the general price index (CPI) has risen more than the index for, let us say, gasoline, then economists say that the real price (the relative price) of gasoline has fallen. If the index for gasoline has risen more than the CPI, then we say that the real price (the relative price) of gasoline has risen.

In principle, these statistical calculations are valid. (In practice, there are some dubious procedures.) They are the only way to answer the question of which prices really have risen over a period of time such as a year or a decade—where “really” means relative to prices in general. Certainly, calculations of this kind contributed to the end of price controls on gasoline in 1979. But this statistical context is the only context in which such calculations are valid. It is also the only context in which the distinction between nominal and real prices is valid.

Look at what the statisticians are saying to people: “the real price is not the nominal price you pay in a store. Instead, the real price is the nominal price you pay adjusted for the rate of price inflation.” But nobody ever pays a nominal price adjusted for the rate of price inflation, because that would not be a nominal price. No buyer, businessman or consumer, ever pays anything but nominal, unadjusted prices, such as $1.60 for a can of tomatoes.

People do not choose what to buy and what not to buy by reference to price indices. But then, what is the relevance of relative prices for human choices based on price? What is the real price?

The essence of the answer is this: All prices are relative prices. An increase in any price is an increase in a relative price. A decrease in any price is a decrease in a relative price. At the same time, all the prices we encounter in the economy are real prices and nominal prices and absolute prices. Most important, and the key to integrating these four concepts of price, all prices are objective prices, where the meaning of “objective” is the meaning defined by Ayn Rand.

We will take up the explanation here next time.