Prices (or exchange ratios between goods) are not primaries. They are derived from something else. They come second. They are implied by other information. You can’t just go directly discover them; they aren’t inherent in reality; they aren’t raw evidence; you go find something else and then calculate prices from it.
The value of each good is a factor in a different dimension. There are no general case conversions between dimensions.
Many individuals make many trades. How is any one trade done? By people judging “subjectively” whether they prefer A to B, and if so they will trade B for A, and if not they won’t. People do critical thinking about which thing will be more valuable to them. Prices are implied by these many binary decisions.
Sometimes people trade using amounts, e.g. 10 pounds of rice. There’s still ultimately a binary decision about whether to accept a particular trade or not. But people also judge, in a narrow context, how much of something they value against how much of something else. It’s a direct comparison normally between only and exactly two factors from two dimensions. When people judge how much they value rice against wheat – what quantity of each they see as equal – they aren’t thinking about corn. It’s not a many-factor decision.
There are two main ways they compare quantities. They either think about what problems stuff will solve in their own lives or they think about using it for future trade, which is ultimately based in solving problems in their lives but more indirectly.
Money doesn’t change the principles.
Anyway, I was rereading Time Will Run Back by Henry Hazlitt (which I like and recommend) and thinking about the connections between the coupon market with its exchange ratios (from the book) and decision making factors in different dimensions (from Critical Fallibilism (CF)). Here are some book quotes:
There is no inherent exchange ratio between bread coupons and cigarette coupons, or between bread and cigarettes.
The gain from the exchange occurs in each case not because of some inherent difference in the relative objective value of the goods themselves, but because each party to the exchange more fully meets his own desires by making it.
“Marx’s labor theory of value was wrong [...] among other reasons, because it rested on the assumption that values were measured by some objective unit, whereas values are only measured subjectively. The value of a commodity doesn’t reside in the commodity; it resides in a relationship between somebody’s needs or desires and the capacity of that commodity to satisfy those needs or desires.... Marx looked for some objective standard of value because he assumed that two commodities that exchanged for each other must do so because of some ‘equality’ between them. But if two commodities were exactly equal, in the opinion of two persons, each of whom held one of them, there would be no reason for any exchange to take place at all. It is only because Peter, who holds potatoes, thinks that a certain amount of prunes, held by Paul, would be more valuable to him, that Peter would want to make an exchange. And only if Paul placed the opposite relative value on a given amount of potatoes and prunes would he agree to make the exchange.”
Similarly, there are no objective exchange ratios between factors in different dimensions. There are no single right answers for conversion factors (as there are between miles and meters, which are factors in the same dimension, length). Instead, the comparative values of dimensions are contextual which Austrian economists call “subjective” – they vary by the relationship between the factor and a person’s needs or desires (which changes over time even for the same person, as his situation, goals, resources, etc. change).
Ludwig von Mises says socialists can’t do economic calculation (without cheating). This is a claim that unit conversions between factors of production can only come from the free market, not from central planners. Why? Because they are “subjective” – they aren’t inherent in the goods themselves, but are instead related in complex ways to individual contexts. So a central planner can’t calculate it because it isn’t a property of the good itself, or of the manufacturing process, or of the statistics on raw materials mined this year, or of any combination of such things.
The ways socialists cheat are to use prices from a market as approximations. They can get prices from memory, looking at another country, or by allowing some trade in their socialist country.
In Time Will Run Back, the plot is designed so there are no other non-socialist countries and the characters can’t remember pre-socialist prices (and conditions changed a lot since then anyway). It’s been 100 years of worldwide socialism, and they destroyed books with capitalist ideas, and they made everyone change to a new language and stop using all prior languages, and they’ve been using the gulag system on ~15% of the population (that’s at present – probably more in the past). The people who remember capitalism are more likely to end up in labor camps (or, to avoid that fate, to never speak of it).
So they wonder how to calculate the total value of all their production for a year, and how to compare it to alternative production plans. Another book quote:
“But, chief, how can you possibly have such a figure? What is 200,000,000 pairs of shoes added to 1,000,000,000 bushels of wheat added to 1,000,000 quarts of gin? It’s 1,201,000,000—of what? You can only add things of precisely the same kind—otherwise the total is meaningless.”
Shoes, wheat and gin are factors in different dimensions. You can’t add them to get a total. This logic matches CF. This matters to planning:
Suppose we increased the production of shoes from 200,000,000 to 250,000,000 pairs a year, but only at the cost of reducing the production of wheat from 1,000,000,000 to 800,000,000 bushels a year. Would we be better off or worse off?
Without prices (exchange ratios between goods, unit conversions between dimensions), they can’t compare goods (or services).
A person can judge, for himself, if he’d rather have one pair of shoes or four bushels of wheat. But a central planner can’t judge which is better for the country.
This is really unintuitive to many people. They’re used to having prices. They don’t understand that socialism would actually lack prices and be unable to figure out basic issues like these. It's hard to envision such a different situation where you don't already have prices and then understand that you couldn't just figure them out easily even though they're so familiar to us.
Similarly, one of the typical attempted answers to CF's multi-factor decision making claims is: just convert everything into dollars to get all the factors into the same dimension. In general in the world today, dollars are the best solution we have for getting many different factors into a common measure of value. People assume that we can do it for everything like we do it for dollars. But we only do it for dollars using a market. You can’t do it without a market. And, further, people typically don’t understand how it’s done with dollars, what actions are required, what limitations there are, etc.
Market prices fluctuate. That’s totally unlike meter-to-mile unit conversions. Why? The prices aren't inherent in the goods. They’re “subjective” (contextual). They fluctuate with supply and demand, which fluctuate both with the conditions of production (how much of what is being made) and also the preferences of traders.
So you can’t just find out the market price and be done. You need to keep the market around to find out about price changes. If you get rid of the market, your prices will get more and more out of date as time passes.
Markets aren't perfect by the way. They don't find perfect prices. They're just a lot better at figuring out prices than any known alternatives, especially for a large society or for trade between strangers.
Market prices are derived. You don’t just figure out the market price because it’s not a primary. It comes out of many individual decisions to make or decline particular trades. People often try to approach decision making by coming up with weights first, but that’s not how markets work. In markets, weights (how much each factor is worth) are implied by what actually comes first, which is individual decision making about specific trades. Weights (prices) are an aggregate that we see second.
The market is our best mechanism for dealing with factors in many dimensions in a unified way, and people typically don’t understand the market which leads to confusions about decision making too. Asking people to make up decision making weights is like asking a central planner to make up prices.
The fundamental thing is critical thinking. Would this trade benefit me right now in my specific context? I try to think of problems with it and problems with refusing it. I try to think of my goals and how different goods can be used to achieve my goals.
Austrian economics doesn’t know specifically how people make their individual decisions. It’s not an epistemology. That’s OK. It just specifies that the decisions are made based on people’s preferences not based on inherent traits of the things traded (those traits are still relevant though), and that different people have different preferences, and that people’s preferences change over time and change as their context changes.
A good (or trade) is a bundle of many factors. Austrian economics doesn’t expect anyone to evaluate each of the many factors, weight them and sum them. It just expect them to choose between bundles. Do you prefer this shirt or that sack of rice? There are many factors by which we might evaluate shirts or rice, and you may take some into account, but you don’t have to do weighted factor math, and aren’t expected or assumed to. Instead, you think about things like whether your old shirt can be mended and whether you have enough food. Those are factors but they don’t aim at anything like comprehensiveness (you can’t ever really be comprehensive). Instead, they are just a few key factors related to your problems and preferences.
People’s assumption that decision makers can assign weights to a bunch of factors is the same basic error as socialist central planners assigning weights to goods to enable them to calculate tradeoffs between different production plans. There’s too much complexity. Instead, people tend to make choices like “I prefer A to B” and if you get enough choices like that organized by a market then you can derive market prices. And then when you get used to market prices, you start thinking in terms of prices (factor weights), and viewing them as normal. But they’re derived and they aren’t available in general, only via markets. They are summaries of market trading.
Market prices don’t tell individuals what to prefer. You can’t/shouldn’t use market prices to know what trades to make. They don’t dictate how much you should value something. You look at market prices to see what trades are available. They tell you your options. You then trade based on differences between your preferences and the market price options. To benefit from trade, you must have some preferences that are independent of market prices, which you then compare to market prices to find differences, and then you trade based on those differences. E.g. you currently value shirts (relative to dollars or potatoes) more than the market does, so you can beneficially trade for shirts. (And if you value shirts less, you could beneficially trade them away to get something else (sell them). Positive and negative differences both enable beneficial trading.)
If your preferences exactly matched market prices, then trade would be neutral for you, not beneficial. Market prices are an aggregate from many people’s preferences which differ from most/all people’s preferences. They’re like an average or blending.
Market prices don’t guide individual preferences. They’re derived from preferences and only useful because they differ from people's preferences. Market prices instead help guide production and trade. They alert people to what their fellow men value highly, so that people can offer it for trade (if they already have it) or produce it for trade.
People commonly don’t understand dollar prices and how those relate to exchange ratios between all the goods. They don’t think about the wheat-rice exchange ratio or “price”, and the shirt-rice price, the potato-rice price, and so on. They only think of prices in dollars. They convert everything to dollars (like generic goodness points in decision making) instead of converting directly between dimensions. To compare shirts and rice, they tend to compare the dollar value of each. They may not even be used to thinking of which they prefer between the two. But they might wonder which of two expensive items they’d rather have, realizing they can’t afford to buy both. They’ll also directly compare two couches, realizing they’ll only buy one (for space, price and/or usefulness reasons).
Instead of pricing everything in dollars, you could price everything in rice. In Time Will Run Back, after a while the market prices everything in terms of cigarettes.
Mathematically, it doesn’t matter what you price things in terms of. Practically, it matters to use something non-perishable, small, light, divisible (for making change), easy to measure and hard to counterfeit – something practical for trade.
Why does the math not care what prices are stated in terms of? Because markets work to make the exchange ratios between all the dimensions consistent, and when we do math we tend to idealize the market and assume consistent prices for all goods. How do markets approach pricing consistency? Arbitrage. When prices are inconsistent, people can trade profitably and this trading makes the prices more harmonious.
If 3 rice is worth a shirt, 2 potatoes is worth a shirt, and 1 rice is worth 1 potato, then prices are inconsistent. You can trade 2 potatoes for a shirt, which you trade for 3 rice, which you trade for 3 potatoes. You gained a potato for nothing. Your trades are also asymmetric: you’re adding demand to trade potatoes for shirts, but not shirts for potatoes. You’re also adding demand to trade shirts for rice and rice for potatoes, but not vice versa. Because you only take one side of each trade, you help move the price. The more you demand potatoes for shirts, but not shirts for potatoes, the more you’ll raise the price of potatoes in terms of shirts. You can keep doing this until the profit from your trades approaches or reaches zero.
After a while, you have to trade 2.33 potatoes to get a shirt, and the shirt only gets you 2.66 rice, and the 2.66 rice only trades for 2.33 potatoes. And so at that point, you trade in a circle, ending up with what you started with (probably slightly less due to transaction costs). The prices are now harmonious. There’s no more arbitrage opportunity.
Since the prices now all match each other mathematically, you could state the prices in terms of any good, and nothing would be inconsistent with that. In some sense, money is basically just whichever good is most popular for trading. Money is used as a store of value (you can sell now and buy later, instead of only trading away something now to get something now) and for indirect trade. Indirect trade means I want a shirt but I can trade with someone who isn’t offering a shirt. I get a shirt through two steps. I trade potatoes for money, then I trade money for a shirt. Without money, indirect trade can theoretically be done but it's likely to involve more steps and more hassle. Money keeps trading steps to two maximum, which is actually more convenient than one step because I can buy and sell as separate trades instead of having to buy from the same person I sell to. I can sell my eggs to one guy then buy a chair from someone else, instead of having to find one guy trading a chair for eggs.
I'll close with one more Time Will Run Back quote related to CF's Multi-Factor Decision Making Math:
“We have already decided [...] that we are working completely in the dark. You simply can’t add things that are unlike each other. Or subtract, or multiply, or divide them, or even, in any meaningful quantitative way, compare them. You can’t add pigs to pears, or subtract houses from horses, or multiply tractors by toothbrushes.”
Time Will Run Back is available for free as an ebook.
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