CHAPTER 10
Price Levels
The subdivision of physical science, known as mechanics, is customarily separated into two parts. First the student of the subject is introduced to statics, which is devoted primarily to the effects of the application of forces to bodies at rest. Then he goes on to dynamics, in which he studies the effects of forces on bodies in motion. In general, he finds that the conclusions drawn from the static principles are not applicable to the dynamic situation. A static balance, for example, does not necessarily indicate a dynamic balance. In order to arrive at the right answers with respect to the dynamic system he must study it as a system in motion, not as a system at rest, and he must apply dynamic principles rather than static principles.
An important point that is emphasized by the scientific analysis of the factual aspects of economic life whose results are reported in this volume is that the modern economic system is a dynamic mechanism, a continuous flow process, while the analytical methods that have usually been applied to the study of economic problems have treated each individual item on a static basis, without adequate consideration of the relation of this item to the flow pattern of the system as a whole. The application of supply and demand theory to a determination of the general price level, for example, is a case of applying static methods to a dynamic problem. As previously mentioned, it gives completely erroneous answers to some of the most significant questions that arise in connection with the price situation. A distinction between static and dynamic processes is frequently made in economic literature, but this is something of a different nature. In the economists’ terminology, the expression “dynamic” is employed with reference to conditions in which the controlling elements of the static process are variable. As explained by Simon Kuznets:
Static economics deals with relations and processes on the assumption of uniformity and persistence of either the absolute or relative economic quantities involved. In contrast, dynamic economics deals with relations and processes on the assumption of change in either the absolute or the relative economic quantities.59
Another author puts the case in this way:
“Dynamics” now denotes analysis that takes explicit account of temporal leads and lags in economic relationships… as against “statics” in which all the variables refer to the same point of time.60
In this present study it has become apparent that fourth stage economic activity is characteristically a thing in motion. Some of its elements are not directly affected by time, but on the whole, fourth stage economic life is a continuous flow: a ceaseless progression down the corridors of time, not a stationary entity that can be analyzed on a static basis, irrespective of whether or not the analysis is modified to allow for “leads and lags.” Most of the basic components of modern economic activity that are customarily visualized and treated independently of time are in reality dynamic entities that can be properly understood and appreciated only if they are studied as moving, working parts of an operating mechanism. In this work the motion—the continuous flow—is recognized as the essence of present-day economic life, and the term “dynamics” is used in the sense in which it is defined in the physics textbooks: “Dynamics is the study of motion in terms of the forces that produce it.”
To the economist who believes that he is already using dynamic methods, and to many laymen who are not familiar with mechanics, the distinction that has been drawn between the economists’ concept of dynamic processes and the scientific sense in which the term is employed in this present work may not seem very significant. However, the inadequacy of the economists’ “dynamics” has been stressed by many observers, even within the economic profession itself. Frank H. Knight, for instance, pointed out years ago that “what it (the economic profession) calls dynamics should be called evolutionary or historical economics.”61 He emphasized the need for a real dynamics. “The crying need of economic theory,” he insisted, “is for a study of the “laws of motion,” the kinetics of economic changes.”62
The difference between the two concepts—the economists’ dynamics and the scientists’ dynamics—can be illustrated by consideration of the forces acting on, and in, a pipeline filled with water. If the line is closed at both ends and left undisturbed, we have a static situation, one in which the various forces acting upon the water and upon the pipe are constant in magnitude, and can be identified and measured independently of time effects. Then, if we connect one end of the pipeline to a reservoir in which the water level varies from time to time, we have the equivalent of the economists’ “dynamic” situation. At any specific moment of time the pipeline and its contents are subject to the same kind of forces and stresses as in the constant static situation, and while a few minor and incidental phenomena—shock waves, for instance—may be introduced, the only major difference is that the physical magnitudes involved are altered whenever the fluctuations in the reservoir change the pressure head acting on the pipeline.
If we now open the other end of the pipeline and allow the water to flow through the pipe, the result is something of a totally different nature. The phenomena that are now of greatest concern to us are such items as pressure gradients, rates of flow, friction factors, etc., which were totally absent from the static picture. Here is a true dynamic situation, one that is not in any sense a static situation modified by the introduction of variable magnitudes and by corrections for “leads and lags,” but a totally different set of phenomena. Our analysis indicates that modern economic life is analogous to this latter situation, and the primary concern of this work is with what Knight called the “laws of motion” or the “kinetics” of the economy.
The foregoing reference to a “continuous” flow in the streams of the economic system does not by any means imply a steady flow. On the contrary, most of our attention will necessarily have to be devoted to the variations in the rates of flow, since it is these variations that introduce problems into economic life. But it is important to realize that the phenomena with which we will be dealing are actually fluctuations and irregularities in a continuous flow process, not independent entities that we can examine and manipulate in isolation.
In this present chapter we will apply this dynamic concept of the nature of the economic mechanism to the determination of price levels and some related economic quantities. It is evident to begin with that man’s economic endowment—his potential labor and his leisure—come to him as a continuous flow, not as an aggregate or a series of aggregates. The arrival of today presents each individual with the potential of a day’s work, which he may put into the economic system in exchange for the benefits that may be derived from such labor. But if he does not choose, or is not allowed, to convert this potential labor into actual labor today, he cannot do so tomorrow. Unless today’s potential is realized today, it is gone forever.
Similarly, the benefits of economic activity must come to him essentially in a continuous stream. So far as the basic needs of life are concerned, there is little more leeway than in the utilization of labor. Food must be supplied continuously. Otherwise, the individual ceases to exist. Clothing and shelter must likewise be available every day if they are to serve their purpose. There is no value in having warm and comfortable facilities available tomorrow if we freeze to death today. After the necessities are provided for, it is in theory possible to take delivery of the additional goods in larger aggregates rather than as a continuous day to day flow, but in actual practice a certain standard of living is established by each individual or family, and this standard of living takes the place of the bare necessities as the level beyond which diversion of some of the flow of goods from immediate use becomes possible. Since there is strong pressure for the standard of living to approximate income, within the range of income of most persons, only a small percentage of the population is able to get very far away from the immediate use of all income, even in the wealthiest countries. Thus the consumption of goods is essentially the same kind of a continuous process as that which provides the potential supply of labor for the production of those goods.
As brought out in Chapter 9, the evolution of the economic organization has taken place in the direction of accommodating the mechanism to this need for a continuous output of goods, and the modern fourth stage economy is definitely a continuous flow process, a true dynamic operation. The basic elements of the process, as shown on the economic flow chart, Figure 1, are the stream of goods flowing from production to consumption, and the auxiliary stream of purchasing power flowing in a closed circuit. Goods and purchasing power are both conserved, as is money, although the ratio of money to purchasing power may vary. We are therefore able to treat both streams by the same specific and precise techniques that are applied to the flow of physical substances in scientific and engineering practice.
Availability of these accurate methods of procedure is particularly helpful when we undertake to analyze price relations. The present-day theoretical approach to price problems is almost entirely from the direction of supply and demand. But to anyone accustomed to dealing with quantities that “stay put,” demand is a highly unsatisfactory subject for analysis. The fact that it is not conserved makes accurate results impossible. Furthermore, the real demand, the quantity of goods that consumers are able to buy at a given price cannot be increased in any other way than by increasing production. (Principle I). The measures that are taken to “stimulate demand” are thus nothing more than devices to produce inflation of the price level. They will be examined in more detail later.
Purchasing power is usually treated rather cavalierly in modern economic analysis. When it is introduced at all it is regarded merely as an antecedent of demand, and the analysis proceeds on the basis of the latter. But it is evident from the points brought out in the discussion in the preceding chapters, and from an examination of the economic flow chart, that the flow of purchasing power is not only a vital element in the modern fourth stage economic organization, but is also susceptible to accurate analysis because it is conserved.
As noted earlier, the conservation laws, which tell us that certain quantities pass through the various processes to which they are subjected without change in magnitude, regardless of how much they may change in form, are some of the most useful tools for analyzing complex phenomena that the scientist has in his repertory. The law of conservation of energy, for instance, asserts that the energy leaving a process is exactly equal to that which enters, plus or minus the energy released from storage or stored during the process. By means of this law we can follow energy from one process to another, balancing our figures as we go, and verifying the accuracy of our calculations at every step. If we find a discrepancy, as we occasionally do, we do not waste time devising some ingenious theory as to why this process differs from all others. We start looking for our mistake, and we always find that there was such a mistake.
Purchasing power is an economic factor, which, as indicated by Principle I, has a similar persistence. Hence we may extend the analogy and set forth a corollary to Principle I, which will serve the same purposes as the law of conservation of energy. Since the circulating purchasing power is conserved, the flow through successive points along the stream cannot vary except in the way that the flow of energy can very; that is, to the extent that reservoir transactions take place along the route. We therefore have
PRINCIPLE VI
The circulating purchasing power arriving at any point in the stream is equal to that leaving the last previous processing point, plus or minus net reservoir transactions.
This principle is valid in terms of real purchasing power as well as in terms of money purchasing power, but storage of real purchasing power can take place only by storage of goods, and consumer storage of goods takes place only to a very limited extent.
The average price in the goods market, by definition, is the quotient of the money purchasing power actually used in the market, the active purchasing power, we may call it, divided by the quantity of goods actually sold. This, the market equation, is a direct mathematical relation that holds good under any and all circumstances, with no ifs and buts to qualify it. By Principle VI, the stream of money purchasing power reaching the goods market is the stream that was created by production, with only such modifications as may have been caused by diversions from the stream to fill money reservoirs, or by withdrawals from those reservoirs, to swell the stream. Thus the active purchasing power is equal to production, in terms of its money value, plus net consumer money reservoir transactions.
In the discussion of reservoir transactions we will treat a withdrawal from the stream (an input into a reservoir) in the algebraic manner, as a negative addition to the stream, avoiding the use of the expression “plus or minus.”
The quantity of goods actually marketed is equal to production plus withdrawals from the goods reservoirs (producers’ stocks). Substituting the foregoing expressions into the market equation that was formulated above, we find that the average goods market price (the price level) is equal to production, in terms of its money value, plus net consumer money reservoir transactions, divided by production, in terms of volume, plus net goods reservoir transactions.
In accordance with the definitions previously stated, the word “production” is used in the general sense as the creation of utilities, and includes the activities involved in the distribution of goods and the rendering of services as well as the production of physical goods. The average price is the average number of units of money per unit of goods volume, regardless of the system of units that is used, and it covers all goods and services marketed, without distinction between capital goods and consumer goods. As should be clear from the context, however, it does not include the items that are handled in the production market: labor and the services of capital supplied to producers. It should also be noted that all of the foregoing discussion of the flow of goods and money refers to the total flow. The extent to which individual products and producers participate in this total is subject to some further influences.
Let us now examine some of the consequences of the relation expressed by the market equation. It can be seen that if there were no reservoirs, either of goods or of money, no change in the general price level could originate in the goods market. On first consideration, this observation may not appear to have any significance in application to real life, since there are reservoirs, both of goods and of money, and they play such an important part in modern economic life that their elimination is practically inconceivable. But even though we cannot eliminate the money reservoirs, it is definitely possible, and indeed relatively simple, to eliminate their effects, so far as the price level is concerned, by introducing oppositely directed reservoir transactions of just the right magnitude to counterbalance the net excess of input into, or output from, the uncontrolled reservoirs.
Thus, at this very early stage of our inquiry, we have already identified the means whereby the fluctuations in the general price level that originate at the market end of the economic mechanism can be eliminated. Various practical methods of accomplishing this result with a minimum of interference with normal economic relationships will be examined later.
Under present conditions, where no such control exists, there will necessarily be occasions when purchasing power is being withdrawn from some money reservoir to swell the stream flowing to the markets. The first reaction to this will be a withdrawal from the goods reservoirs. This has the same effect on the markets as an increase in production, so it maintains the equilibrium between money and goods at the existing price level. But since the goods reservoirs are very small compared to the large money reservoirs, they are soon effectively empty, and the goods stream reverts to the volume of production. Then, unless the withdrawal from this money reservoir is counterbalanced by an input into another reservoir, the price level must go up. No other result is mathematically possible. Similarly, if the net reservoir transactions are in the other direction, prices must drop.
Before going farther, let us stop for a moment and consider the significance of the points that have been developed thus far in the discussion. We have set out to determine just why the market price is unstable. Previous investigators have given us an assortment of theories, but freely admit that none of them provides a satisfactory answer, and have not been able to arrive at any consensus. Now we have gone ahead with a factual analysis by scientific methods, and we hardly get started before we encounter some basic principles that clarify the entire situation.
We produce goods, and the exact amount of purchasing power required to buy those goods, simultaneously in a single operation. Production of goods and creation of purchasing power are one and the same thing. But we have translated the purchasing power into terms of money, and we have set up a series of reservoirs in the money stream between the production market and the goods market. By the use of these reservoirs we vary the money flowing to the goods market so that it is sometimes more than enough to buy all of the goods that are produced, at the full production price, sometimes less. But the flow of goods continues without change, except as modified by the relatively small goods reservoirs. So when excess money enters the markets, the ratio of money to goods (the market price level) increases. When some of the money in the circulating stream is being withdrawn to refill the reservoirs, the general price level drops.
Many readers will no doubt find it difficult to believe that the answer to an important problem of such long standing can be so simple, but it does not take any complicated or intricate reasoning. The logic is plain enough for anyone to follow, and the conclusions meet the ultimate and exacting test of science: they are consistent with all of the known facts. Accomplishment of these results in an area where theory has hitherto been confused and uncertain has been possible because the concept of reservoirs in the circulating money stream, like the concept of energy in physical science, enables us to recognize the equivalence, from certain standpoints, of apparently dissimilar phenomena, and to define their effects in that respect with precision, independently of any other aspects that they may possess.
The fidelity with which the reservoir theory conforms to all of the established facts concerning business fluctuations will be clearly demonstrated in Chapter 14, where the mechanism of the business cycle will be explained in detail. For the present it will suffice to point out that it is quite evident from the mass of business and monetary statistics now available that the booms and recessions that we have actually experienced have displayed exactly the same characteristics as the fluctuations which we can see must inevitably result from the presence of uncontrolled reservoirs in the circulating money stream.
A few more points in connection with the price mechanism should have some attention. The market equation demonstrates that, so far as the goods markets are concerned, prices are not affected by the volume of production. Any change in the volume of goods produced is accompanied by an equal change in the amount of purchasing power (both money and real) that is created. (Principle III) Since money purchasing power and volume rise and fall together, the quotient is not altered (except to the extent that the relative magnitude of the reservoir transactions may be modified). It should be noted that this does not mean that the volume of production is unaffected by price changes. That is another matter altogether, but it is outside the scope of the present discussion of the goods market price level, and it will be taken up separately.
Inasmuch as the modern fourth stage economic system operates on a dynamic basis, the significant economic quantities are the differential quantities, the rates. The magnitudes of the integral quantities, the accumulations at the various locations, are for most purposes irrelevant. The amount of money stored in the various reservoirs, for instance, has no effect on the price level, as a given rate of withdrawal from a full reservoir has exactly the same effect as an equivalent rate of withdrawal from one that is nearly empty. In the latter case, the state of the reservoir has a bearing on how long that rate of withdrawal can continue, but as long as it does continue, the condition of the reservoir is immaterial.
This means, of course, that the quantity of money in the circulating system is completely irrelevant, except insofar as the rate of flow may be changed by some process that involves an input into, or a withdrawal from, this stream. This conclusion will no doubt be distasteful to those who look upon the “money supply” as the governing force in economic activity, but the rate of flow of money is the significant item, and this flow rate is not a function of the total quantity in the system, any more than the rate of flow of the water in the automotive cooling system is a function of the amount of water in the radiator. These facts are practically self-evident as soon as the characteristics of the money purchasing power flow are given a close examination, but in view of the large amount of attention that has been given to this question as to the effect of the quantity of money on the price level, this subject will be examined in detail in Chapter 15 in connection with a discussion of other aspects of money and credit.
Purchases of goods by producers for production purposes do not affect the general price level. Such purchases are simply exchanges at the same economic location, the same point in the mechanism. The total amount of goods in the hands of producers is exactly the same as before the transaction, and the same is true of money purchasing power. So far as the general situation is concerned, transactions between two or more individual producers have the same standing as transactions between departments of one large producer.
This is another fact that may be difficult for some of those accustomed to current economic thinking to accept. The statistical economist pays little attention to retail trade, other than in total, focusing his vision on wholesale transactions, and particularly on the organized commodity exchanges, where economic data are more readily available. This has fostered the impression that these wholesale transactions are the most important part of marketing. But it can easily be seen that the prices, which are arbitrarily assigned for accounting purposes to goods transferred between departments in a single productive enterprise, have no important economic significance, and it is equally clear that from the general economic standpoint transactions between producers have the same status as these intra-company transactions. A railroad, which mines and transfers coal from its mines to its railway, is carrying out the same economic transaction as the railroad, which buys coal from an independent producer. Here we again meet Principle IV. All producers are at the same economic location. Hence transactions between producers, or between departments, have no effect on the flow of the economic streams, regardless of the volumes of goods involved, or the prices at which sales take place.
At a given level of production, the basic factor which determines the general price level is not the price which one producer charges another, or the price which the producer of the finished product attempts to get from the consumer. The determining factor is the amount, which the producers pay out through the production market for the labor and services of capital that they utilize. The total of these payments is the total money purchasing power generated at the production end of the economic mechanism, and, aside from the effect of the reservoir transactions, which balance out in the long run, it is the total purchasing power utilized in the markets. The quotient of the active money purchasing power divided by the volume of production is the general market price level to which the average of all individual prices must conform. If the prices that the producers try to establish exceed this level on the average, the producers that are in the weakest market position simply have to bring their prices down.
Here we can see the difference between the determination of the general price level and the determination of individual market prices. The general price level is determined in the production market, as the production price level is also the normal goods market price level, the level that exists in the absence of unbalanced reservoir transactions. The relative values of the various products are then determined in the goods market by supply and demand considerations; that is, the function of the price system in the goods market is to divide up the total incoming money among the various goods according to the consumers’ preferences. It is commonly taken for granted that the prices of individual goods are determined by the interaction of supply and demand in the market, and that the general price level is the average of these individual prices. But this is not the way that the system operates. The general price level is a result of a set of factors totally independent of the goods market.
The distinction between purchase of producer goods and purchase of capital goods should be noted. Producer goods, including materials purchased for use in maintenance and repair of capital equipment, are bought with funds that would otherwise be available for buying labor and the services of capital in the production market. The purchase of such goods is, in fact, merely an indirect purchase of labor and the services of capital, and the cost of these goods will be reflected in the selling price of the producer’s products. But goods purchased as additions to capital assets are not bought with funds available for buying labor and capital services in the production market. They are bought with funds that have already been used for this purpose, and have been paid out, actually or constructively, to workers or owners of capital.
The accounting procedures that are prescribed for regulated enterprises such as the public utilities show this distinction very clearly. Producer goods—materials and supplies for use in operation and maintenance of facilities, raw materials for use in manufacture, etc., are charged against the operating accounts of the enterprise, and the business is ultimately reimbursed for these costs in the sale of its products. But the regulatory authorities will not permit the enterprise to charge its customers a price that will recover any of the cost of capital additions, or will enable it to lay aside funds, other than reserves to cover depreciation and other deferred expenses, for future construction. If the enterprise wishes to expand it must obtain the necessary funds through investment channels, either by borrowing, by selling additional stock, or by persuading its existing stockholders to “plow back” some of the money that would otherwise be paid out in dividends.
Private sales between consumers (exchange of goods for money) or trades (exchange of goods for goods) are exchanges at the same economic location, and therefore have no effect on the streams of goods and money purchasing power, and no effect on the general price level. Examination of this situation on the basis of supply and demand is likely to lead us astray, but when it is analyzed by means of the purchasing power relations the answer is clear and unmistakable.
Use of goods from consumers’ storage likewise has no effect on the general price level, under normal conditions. This is another of the places where the supply and demand approach to economic problems is likely to be misleading. It is generally assumed that the consumption of goods withdrawn from consumers’ supplies would reduce the demand for currently produced goods, and thereby lower prices. This could conceivably happen in the case of individual items. Consumers might, for example, decide to wear out the clothes, which they already own rather than buying new clothing in the usual quantities, with a consequent detrimental effect on the clothing market. The purchasing power analysis shows, however, that this would not change the total amount of money purchasing power flowing to the market, and the decreased buying of clothing would be offset by increased purchases of other goods. The general price level would not be affected.
It is possible, of course, that money made available through sale or use of stored goods may itself be stored or utilized for debt retirement, in which case the final effect on the markets might be different. But this does not necessarily follow, and in any event the consumer’s decision has no bearing on the result. If he decides to save the money rather than spend it, he deposits it in a bank, and the bank then lends it to someone else, who spends it. No input into the money reservoirs occurs unless some other factor causes the bank to add the money to its reserves instead of lending it to a customer. Such other factors are independent of the goods transaction and they will be analyzed separately. It should be noted in this connection that no assumption is being made as to what the ultimate result of the goods transaction will be. The point that is now being brought out is that use of supplies on hand does not in itself cause any change in the flow of purchasing power. Input into the purchasing power reservoirs, if it follows, does alter the stream flow, but the two matters have no essential connection with each other, and they are therefore being treated separately in accordance with the scientific practice which has been followed throughout the entire study.
Another example of a transaction between individuals at the same economic location is a shift of purchasing power from one group of consumers to another. There is one school of thought, which holds that the root of some of our present difficulty in maintaining a consistent high level of production, is a misdistribution of purchasing power among the various economic and social groups. The present analysis indicates, however, that no economic benefit can be obtained by a redistribution of purchasing power. The general price level is determined by the total flow of money purchasing power into the markets, without distinction as to the source or as to the kind of goods purchased. Whatever instability of the price structure may exist is due entirely to reservoir transactions.
The usual argument in favor of these redistribution proposals is that the spending pattern of the higher income groups is less stable because they save more of their income, and the amount of their saving is likely to vary, thus creating fluctuations in the general level of consumption. The flaw in the argument is that variations in the amount of saving do not normally affect the market mechanism. The more affluent groups do not hoard their savings; they invest them, which means that this purchasing power is spent for capital goods, and such spending has exactly the same effect on the purchasing power stream and on the markets as an equivalent amount of spending for any other type of goods.
These proposals for redistribution of income have a great deal of support because they provide an apparent justification for taking from the “haves” for the benefit of the “have nots,” but from the standpoint of the economic purpose which they are ostensibly designed to accomplish they are of no value. Our policies with respect to taxation and other factors, which influence the distribution of income, are far from perfect, and some modifications and improvements from time to time are undoubtedly in order. But these should be considered on their own merits, and not on the basis of their purely mythical contribution to economic stability.
The three important generalizations developed in the foregoing discussion may be summarized in the following principles:
PRINCIPLE VII
Except as modified by reservoir transactions, the purchasing power (money or real) available in the goods market is equal to the purchasing power expended in the production market.
PRINCIPLE VIII
Any net change in the levels of the consumer purchasing power reservoirs results in a corresponding change in the money price level in the goods market, except insofar as it may be counterbalanced by a net change in the levels of the goods reservoirs.
PRINCIPLE IX
The market price levels are independent of the volume of production.
The principles that have been stated thus far, and those that will follow, are not all on the same logical level. For instance, Principle I is a statement of the basic fact of the conservation of purchasing power. Principle VI expresses the effect of this conservation on the flow in the circulating stream, Principle VII, is a restatement of Principle VI in the form in which it is specifically applicable to the determination of the price level in the goods market. Thus there is considerable overlapping and duplication in the list, but this appears to be necessary in order to accomplish the double purpose of defining the basic economic relations in the way in which they will be applied to specific situations, and at the same time indicating how these relations are derived from the broad general principles that govern economic life as a whole.
For the benefit of those who prefer to analyze the situation mathematically, the essence of this chapter can be set forth in a few equations. This economy of time and effort in the development of thought is characteristic of mathematical treatment in general, and to take advantage of the additional clarity of presentation that is made possible by this means, the appropriate mathematical expressions will be formulated in connection with the explanatory discussion from this point on. For this purpose the following symbols will be used:
V = Volume of goods
B = money purchasing (Buying) power
P = Price
To indicate changes due to voluntary actions affecting the operation of the economic mechanism, a series of factors denoted by lower case letters will be employed.
- change in the volume of production
- consumer money reservoir transaction
- producer money reservoir transaction.
- goods reservoir transaction
- change in production price
This list may seem very short for a classification, which purports to represent all of the things that man can do to influence the general operation of the exchange mechanism, but it is complete. The explanation of the brevity is, of course, that the term “reservoir transaction” covers a great diversity of actions, all of which we are able to classify under no more than three headings, since all actions in each of these categories have exactly the same effect on the general operation of the economic mechanism. This recognition of the equivalence of apparently unrelated phenomena is extremely useful, and it has been one of the major tools of this analysis.
It will be noted that a symbol has been provided for a voluntary change in production price, but none for a similar change in market price. The reason is that the market price level cannot be changed by direct action. As explained in the preceding pages, this price level is a resultant, the quotient of the active money purchasing power divided by the volume of goods entering the market. It can therefore be altered only by an action which modifies the flow in one or another of these two ways; that is, a change in production price (symbol f) or a reservoir transaction (symbols c and e). It cannot be changed arbitrarily, nor is it affected by an increase or decrease in the volume of goods produced, since any such change is accompanied by an equivalent change in the money purchasing power stream (Principle IX).
The impossibility of any direct manipulation of the market price level, a point which has not been generally recognized heretofore, but was brought out clearly by the cooling system analogy in Chapter 8, is very significant, as it stands squarely in the way of the success of price control and similar economic actions, and it imposes an overall limitation on the ability of individual producers to set prices for their products. These matters will have more detailed consideration at appropriate points in the subsequent chapters.
The proportionate effect of any change in the quantities that affect the price level will depend not only on the magnitude of the change itself, but also on the magnitude of the original quantity that is being modified. In order to take this into account, these changes will be expressed as percentages of the base quantities rather than as additives. In the case of a change in the volume of production, for instance, if we denote the actual additional volume as V’, the factor a will be equal to (V+V’)/V.
The market equation, which we will find applies to the production market as well as to the goods market, and will therefore be designated as the GENERAL ECONOMIC EQUATION, can be expressed as
B/V = P
Using the notation that has just been specified, we can now state Principles VIII and IX in this manner:
PRINCIPLE VIII
cB / V = cP
PRINCIPLE IX
aB / aV = P
These relations are mathematically exact, not speculative or empirical. They hold good whether the transactions take place through the medium of money or by some credit arrangement, whether the goods are durable or transient, capital goods or consumer goods. Prices rise when purchasing power is being swelled by reservoir withdrawals; they fall when the stream of purchasing power shrinks because of diversions to replenish the reservoirs. The fact that many economic activities are still being carried on by combination producer-consumers who do not utilize all of the advanced fourth stage economic processes does not alter this situation. The flow of purchasing power follows the same economic channels as in the newer type of organization. There is merely one less point along the line where the flow can be modified.