Price vs Value

It seems to me that most people, and especially most non-Austrian economists, tend to erroneously equate price with value. There are too many components involved in completely demonstrating why this is wrong for this short a post, but a simple example may be instructive.

On your way to work in the morning, your typical path takes you to a smoke shop where you spend fifty cents for a newspaper and a dollar for a candy bar.

On most days you reach into your pocket and find two twenty dollar bills, one of which you break to pay for your purchases. On this particular day, you only find two one dollar bills. It is still physically possible to buy both the newspaper and the candy bar. Why might you choose to change your normal purchasing habit? (Please refrain from suggesting all kinds of non-economic possibilities, such as reading your co-worker's newspaper, etc.)

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Because the opportunity cost

Because the opportunity cost of purchasing the candy bar and newspaper is higher when you only have two dollars as opposed to 20 dollars in your pocket, you may wish to refrain from your common morning purchases in favor of consumption later in the day or consumption that provides a longer-lasting sort of satisfaction. The change in consumption isn't certain (it depends on how much you value newspapers and candy bars compared with other things such as coffee at the office), but the change in opportunity cost is.

Maybe this is basically the

Maybe this is basically the same thing as opportunity cost, but it seems like I've just realized that physical dollars in my hand are a scarce resource today, so I'm going to be more careful about spending them.

In particular, say I know that I have plenty of dollars in my bank account so the fact that I have only $2 means I forgot to grab money that is available to me. In this case, $2 in my hand is worth more than the $2 in the bank (this is a world without debit I guess) because there is a cost associated with going out of my way to get the $2 in the bank to replace the $2 that I'd spend on the convinience things, in case I want to make other purchases today.

In Canada where $1 and $2 are coins, if you need to use change to run the laundry machine (and there are no change machine in my building's laundry room), then 5 $1 coins are worth more than a $5 bill on a laundry day. Maybe the merchant is actually doing me a service by breaking my twenties, the $1.50 is the cost and the coffee and paper were side benefits to the true transaction.

David and Tim!, I find both

David and Tim!,

I find both of your comments quite valid, but I prefer a more general approach than a time delayed opportunity cost, but it may partially be a matter of taste.

In the morning, buying the candy bar means that it is valued higher than its $1 price. There is no particular reason here to assign a different value to the candy bar from day to day, especially in synchronism with the amount of money in your pocket. It therefore follows that it must be that the value of the $1 price must be higher than the candy bar if you refrain from buying it when you have less money in your pocket. But this is exactly what you would predict if the law of diminishing marginal utility applies (in reverse) to money, and it does. As you spend down your money, every dollar given up sequentially is worth more than the previous one as you approach exhaustion of your stock of money.

The value of money is the result of supply and demand.

The demand for money is always a demand to hold money. The demand to hold money is always the result of an uncertain future. If you knew in advance exactly what and when you would need money to spend, then you could either invest it at interest (not important for this short term problem), or arrange for advance purchase discounted prices. In neither case would there be any need to actually keep money in your possession and compete with everyone else to hold part of the world's total supply of money. It is only in this sense that money has an economic scarcity value. The actual spending of money does not impinge on the world's total supply of money as it is just transferred from one owner to another. All money is always owned by someone.

The utility of holding money is its ability to be used to meet both emergencies and opportunities which are unable to be predicted in specific detail. You might need to have a flat tire repaired, or to take advantage of a two-for-one sale you may come across. In short, the usefulness of money does not simply result from its spending, but from its holding as well.

Thus, any idea that the value of money is constant across either time or individuals, or that the values of goods can be equated to their prices, has no validity.

Regards, Don

Because the opportunity cost

Because the opportunity cost of purchasing the candy bar and newspaper is higher when you only have two dollars as opposed to 20 dollars in your pocket, you may wish to refrain from your common morning purchases in favor of consumption later in the day or consumption that provides a longer-lasting sort of satisfaction.

This seems wrong to me. The opportunity cost of buying the candy bar and newspaper is the same whether you have $2 or $40 on you. Opportunity cost is whatever you give up by buying the candy bar, which in this case would be [everything else you can get with $1.50]. Don's answer makes much more sense -- holding money is insurance against uncertainty.

Opportunity cost works. If

Opportunity cost works. If you have $40, you can buy the newspaper, the candy bar, and $38.50 worth of other stuff. If you only have $2, then you only have fifty cents left over to buy other stuff. Supppose the most important thing you intend to buy today is bus fare, at a dollar each way.

If you have only $2, buying the newspaper and candy bar means giving up the bus fare. But if you have only $40, it means giving up something less important. The opportunity cost is greater if you have less cash.

Brandon, I'm still not sure

Brandon, I'm still not sure that that's right. Let's simplify it and play it in reverse: say the candy bar and the bus are both $1, and that's exactly how much you have on you. Your opportunity cost for getting the chocolate bar is one busride. You decide that riding the bus is worth more to you. Then on your way to the bus, you find another $1 on the ground. Now what is your opportunity cost for buying the chocolate bar? Still one busride. (Assume no transaction costs, all the usual caveats.) Now play this back the other way around, starting with $2 and then having one bill blow away on the wind. There isn't any difference in opportunity cost.

That's assuming I've got this whole OC thing right, which I wouldn't stake my life on... can we get any professional economists in the house?

(PS: I should be clear that I follow Tyler in considering OC to be gross rather than net, if it matters.)

(PPS: I should also be clear that I'm not saying you shouldn't also buy the candy bar, just saying that in accounting terms the on-paper OC remains the same. I take OC to be a price-level concept, not a value-level concept. This may or may not be wrong, I honestly don't know.)

Speaking of professional

Speaking of professional economists, here's Munger. I think he agrees with me, but now I'm just too tired and addled to tell...

Then on your way to the bus,

Then on your way to the bus, you find another $1 on the ground. Now what is your opportunity cost for buying the chocolate bar? Still one busride.

I don't think this is so. Since you now have two dollars, the bus ride is no longer the OC of the candy bar, because you don't have to choose. You now can choose between a candy bar and something else, perhaps a second bus ride.

David is right in that Matt

David is right in that Matt is wrong. The OC is the first thing you can't get once you order your preferences. Means are applied to ends in the order of highest importance first. As you get more means, you can apply them to less and less important ends (i.e., the margins move).

Taken as a stock, all units take on equal value (since we don't distinguish one unit from another), that of the least important end served (i.e., the marginal benefit). In the $40 case, lots of ends can be served, so we get pretty far down the wants list, so each of the $40 isn't too valuable. With only $2, we can only satisfy very important ends, and each dollar takes on the commensrate value.

All, I have an ill-defined

All,

I have an ill-defined level of discomfort with the opportunity cost approach, particularly a money-centric approach.

Money is not only a means of making specific purchases, but holding it is a means of making provisions for an unpredictable future, reducing unease in the present.

A reduction in the level of money held may be similar to the following question --

What is the opportunity cost of spending next month's health insurance premium on something else?

Regards, Don

Damn internet! *shakes

Damn internet! *shakes fist* Been reading the comments from the Clapton/Dylan opporunity cost post on MR. Need sleep.....

But first:

What is the opportunity cost of spending next month’s health insurance premium on something else?

Chapter 1, Human Action: means --> ends. To answer your question: the first thing you don't buy with the money (alternately, the first thing you would buy if your supply of means increased). The sticky point, which also seems to be the sticky point on MR, is deciding on the dollar value to assign that forgone opportunity. Net, gross, etc.

This also relates to my

This also relates to my previous opinion that monetary theory is concerning oneself with the "why" of demand. Marginal supply and demand analysis doesn't care about "why", and still applies.

Please forgive any poor

Please forgive any poor gramatical construction. It's nearing 4am, and I have class tomorrow this morning.

Matt: If you have forty

Matt:
If you have forty dollars, you're not going to buy forty bus rides. You're going to buy two bus rides and some other, less important stuff. If you only have two dollars, buying the paper and candy means giving up the bus ride. If you have forty dollars, you don't have to give up the bus ride to buy the paper and candy. You give up something less important. Ergo the opportunity cost is lower.

I think the answer that

I think the answer that makes most sense is that the DMU of dollar bills increases with fewer bills in possession. Because money stores value, it is demanded due to uncertainty in the future. The less you have, the less you want to 'waste' it on candy bars.

Wilde's first law of

Wilde's first law of economics discussions: opportunity cost is a concept whose definition everyone thinks everyone agrees upon, but in reality, everyone doesn't.

Cornelius, Damn internet!

Cornelius,

Damn internet! shakes fist Been reading the comments from the Clapton/Dylan opporunity cost post on MR. Need sleep…..

Thanks for pointing this out. The correct comment is the following :

The concept and logic of "opportunity cost" was developed by Friedrich Wieser. It's pretty clear that Mr. Tabarrok has no better understanding of opportunity costs than does your average "professional" economist -- or the folks who designed this question.

Opportunity costs are "subjective", they consist in ALL of what is given up in a choice, and they CANNOT BE MEASURED, not by dollars, not by anything. It is simply the incompetence of "modern" economic training which creates the intellectual illusion that such things can be demarked in dollars.

I can't believe there aren't economists at George Mason who are well aware of all this.

Posted by: prestopundit at Sep 4, 2005 1:53:53 AM

The problem is that money (and a price) is not a measure of value, but an economic good in its own right. Utilities are ordinal and can only be ranked. They are not subject to any mathematical operation except greater.than or less.than.

More later if my idea for a demonstration does't blow up or evaporate.

Regards, Don

Don, Agreed.

Don,

Agreed.

Brandon, David, Cornelius, I

Brandon, David, Cornelius,

I don't disagree at all with your reasoning and will readily concede that your definition (esp. the way Cornelius put it) makes more sense. I'm just not sure that it's the way that economists generally define OC, since the example I used seems to be isomorphic to the one Munger uses in the essay I linked to. But I suppose we could be like Greg Ransom and just say "so much the worse for most economists." Wilde's First Law sounds right to me...

Matt, FWIW, I thought

Matt,

FWIW, I thought Munger's "obvious" OC demonstration was anything but- seemed like an advanced exercise in semantics, since his definition and understanding gave us exactly zero difference from the "unwashed" heuristic approach. Occam's razor at the very least would argue against his (IMHO) silly view and in favor of the "yes, I have two tickets that I didnt have before and now I am wealthier" notion.

And seriously, any argument that critically depends on "transaction costs are zero" isn't worth the electrons it's displayed on...

Okay, here I am coming in

Okay, here I am coming in late, but I feel compelled to reply... because although all the comments about opportunity cost have been vaguely entertaining, they've ultimately been a distraction. I believe Don's point was aimed squarely at me and consists of this:

Thus, any idea that the value of money is constant across either time or individuals, or that the values of goods can be equated to their prices, has no validity.

I have on several occasions here (usually in reply to Don's posts) made noises about the benefits of price level stability as maintained by an appropriately inflation-targeted monetary policy by central banks, said benefit being that money then becomes useful for intertemporal comparisons. Don's point seems to be to take issue with that.

If so, then I call hogwash.

(If not, then I have an overinflated sense of importance. Actually, that's probably true no matter what Don's point was.)

My first thought in reading Don's post was "congratulations, you've discovered liquidity." Don's example makes quite clear that 1) liquidity is valuable, 2) everything is valued on the margin, and therefore 3) when you have less liquidity you are less willing to trade it on the margin. Don *fails* to make the point I think he intended to make - that trying to use money to establish intertemporal (or for that matter interpersonal) value is futile, and thus by implication all this nonsense about hoping the Fed keeps the price level stable is exactly that, nonsense, so let's all go back to gold the way that God and Mises intended.

Don, I hope you'll forgive my rhetorical excess here, but please correct me if I've misunderstood your point.

Don's explanation in the third comment is absolutely dead on until the last paragraph (which I quoted above). The value of money is not the same as the face value of money; it like all things is subject to the laws of diminishing marginal utility, so that the first of twenty dollars is less valuable than the last. So too are the values of things not equal to their prices; everything for sale is valued by the seller at or less than its price and by the buyer at or more than its price, and only rarely would those two value be equal (if they were, there could as easily be no exchange as an exchange, since both buyer and seller would be indifferent between the thing sold and the money sold for).

Value does not equal price. The value of things is different for different people. If it weren't, there wouldn't be trade.

That doesn't mean that prices are irrelevant, either intertemporally or interpersonally. And it sure as hell doesn't make a case against price level stability.

Let's look at this again in slow motion:

Thus, any idea that the value of money is constant across either time or individuals, or that the values of goods can be equated to their prices, has no validity.

"The value of money". That's what my thesis about price stability hinges on, right? And Don has convincingly shown that the value of money (and in fact all things) is not constant (and that's just for a single person based on diminishing marginal utility - he hasn't even touched on the question of ordinal utility, revealed preferences, and other Austrian hotbuttons). So whence price stability if the value of money is inconstant?

Whence? Why, just look in the margin, of course.

Price stability isn't about ensuring that every dollar that every person holds is equally valued. Price stability is about ensuring that the market price of stuff [1] remains constant [2] over time. And what is the market price? The price at which the *marginal* seller and the *marginal* buyer will exchange stuff for money. When it comes to price level stability, the value of money means the *market* value of money, not the value of any individual piece of money to any individual holder. And there's absolutely no reason that can't be kept constant through appropriate policy from the monetary authorities.

And I maintain that it should be, and that under competitve free banking it would be, and luckily for us it mostly is even under the Fed money monopoly [3].

[1] handwave

[2] more handwave

[3] as opposed to Monopoly(tm) money, which is something completely different, although you wouldn't think so to hear the Austrians talk about it.

eddie, Thank you for your

eddie,

Thank you for your comment. I just picked up your comment in the process of posting on opportunity cost, so I will only respond to the extent that I don't think this particular subject ( I haven't reread it to be sure) was meant to address price stability or intertemporal change. I definitely have problems with artificial attempts to stabilize prices, especially by playing with the money supply, but I see the issues as being almost completely different.

Regards, Don