It is notable that the whole conception of a general change in price level has been gradually falling into disfavor in recent years. In considerable part this has been due is the recognition of the fact that prices do not tend to move up and down together. Rather, when a general index of prices moves down, it is likely that the sensitive prices will fall very much more than the administered prices, with the reverse behavior in the case of a price rise. The whole conception of a general change in price level does not apply to such price behavior. Yet the impediment to general price changes would seem to be the presence of insensitive prices and of price administration. If all prices were “made in the market,” and therefore as sensitive as most agricultural prices, the concepts of a price level and of general price changes would be appropriate so long as the constant flux of individual price relationships to conceive of wage rates that are as sensitive as goods prices and of general changes in the price-wage level, though of course the latter conception is appropriate only to a sensitive-price economy. - Gardiner Means (Means 1947, pages 33-34).
What is inflation? The Oxford dictionary defines inflation as “A general increase in prices and fall in the purchasing value of money”. What does a “general” increase in prices mean?For that matter, what is “the value of money?”. We are so accustomed to the concept of inflation and “the value of money” that we rarely fundamentally question them. From the perspective of economic theory however, there is no prima facie compelling reason to think these are coherent theoretical concepts. This does not mean we can’t construct an index of prices, but not every index has a coherent analytical vision behind it (for a famous example, look at the misery index). The late great Fred Lee liked to say “all economic theory is product specific and price specific”. This means that a theory can only coherently explain the behavior of individual products and prices and one can’t presume it also applies to the behavior of an index. Indices can change because of all sorts of reasons that have nothing to do with the underlying dynamics explained by theories.
In traditional neoclassical theory, the theoretical edifice behind a price index is that there is one generalized “value of money” and an index of current consumer goods and services prices successfully measures it. The fundamental forces of supply and demand are supposed to determine relative prices and the quantity of money straightforwardly determines the overall price level through determining “overall” demand. These theorists presumed that you can aggregate individual product, individual firm demand and supply curves into “market” demand and supply curves. You can then put all the product demand and supply curves into a general equilibrium system where the same forces determine relative prices and thus money has no role besides as a numeraire (the famous “Hahn problem”). Thus they had a product specific and price specific theory which they assumed was aggregatable to the macroeconomic level. However, none of these steps have proven to be true ( Andrews 1964, Jo 2016, Lee et al 2004 and Moudud 2012). Thus there is no neoclassical theoretical foundations for a monolithic “general” price level.
Since there is no unitary force moving "general prices" in contradistinction to relative prices, there is no unitary value of money. There is only a range of things you can buy at different prices. Why then do we persist in treating Consumer Price indices as fundamental? Why is the same index used to adjust everything from wage contracts to social security? In other words, if effective demand doesn't determine the price level but only impacts specific prices, and only weakly at that, what theoretical meaning does a price index have? So the consumer price index grew 3 per cent faster, so what? Does that say something about the value of money in general or did 6 industries increase their target profit margins? Did product quality change significantly across a number of products important to consumers? Neoclassicals try to get around the product quality issue by “quality adjusting” price level indices. However, once you don’t have some homogeneous substance which is the “essence” of all output (whether that substance is labor time, or utility) there is no theoretical basis for such adjustments.
Using developments in Post-Keynesian theory originating with Means I would argue that an index of consumer prices fixed relative to organized exchange prices and an index of administered goods and service prices could be constructed separately in a coherent way. I would further make the case for constructing an index of tradable administered price goods and services and non-tradable ones since they behave differently (whether because of baumol disease productivity factors or because non-tradable goods face localized and more geographically concrete competition). However, the reason to construct these indices isn’t to claim all the prices in the index will change for the same reason but simply to say that they are more similar to each other than the prices in other indexes. Nor would we any longer be driven to claim that faster growth in one more more of these indexes necessarily says anything about the state of effective demand and thus necessarily implies that x or y macroeconomic policy is worthwhile.
It is interesting to note that Keynes in the general theory comes to a similar conclusion. He says in the greatly underrated chapter 4 that, “...the well-known, but unavoidable, element of vagueness which admittedly attends the concept of the general price-level makes this term very unsatisfactory for the purposes of a causal analysis, which ought to be exact”.This leads to one of the greatest statements on quantitative analysis ever made:
To say that net output to-day is greater, but the price-level lower, than ten years ago or one year ago, is a proposition of a similar character to the statement that Queen Victoria was a better queen but not a happier woman than Queen Elizabeth — a proposition not without meaning and not without interest, but unsuitable as material for the differential calculus. Our precision will be a mock precision if we try to use such partly vague and non-quantitative concepts as the basis of a quantitative analysis
This is a well known set of issues; yet strangely heterodox economists have not really taken it up. You can still find plenty of heterodox economists uncritically speaking of “inflation”. A fruitful avenue of future research would be reorganizing data to be coherent from a heterodox economics point of view. From here we can ask what different policy implications would heterodox economists derive from multiple price indices, including multiple indices of asset prices?
Andrews, P.W.S. 1964, On Competition in Economic Theory, Macmillan & Co Ltd, London, and St. Martin’s Press, New York.
Jo, Tae-Hee. "What if there are no conventional price mechanisms?." Journal of Economic Issues 50.2 (2016): 327-344.
Lee, Frederic S., and Steve Keen. "The incoherent emperor: a heterodox critique of neoclassical microeconomic theory." Review of Social Economy 62.2 (2004): 169-199.
Keynes, John Maynard. 1936. The General Theory of Employment, Interest and Money. London: Macmillan.
Means, Gardiner Coit, Warren J. Samuels, and Frederic S. Lee. A monetary theory of employment. ME Sharpe, 1994.
Moudud, Jamee K. "The hidden history of competition and its implications." Alternative Theories of Competition: Challenges to the Orthodoxy 14 (2012): 27.
The Comparative Advantage story is famous. It is an essential part of nearly every undergraduate economics education. It’s propagandistic benefit is also well known. To review, I’m going to run through a numerical example.
Here we see that Robinson Crusoe has an absolute advantage in everything. That is, he can produce more of either type of output than Friday can. Oh no! Poor Friday! But wait, David Ricardo is to the rescue! As long as Crusoe’s absolute advantage over Friday is different for producing Rice than producing Grapes, the opportunity cost (what else he could be doing with that time and resources) of Crusoe producing grapes is higher than Friday producing grapes! Boom, gains from specialization and trade.
You can see here that this is precisely what we find. The table is clearly telling us that Friday should produce grapes while Crusoe produces rice. However, what happens if there are increasing returns to scale? Below I run through such an exercise.
Below I’m assuming that for each year Crusoe spends producing rice with specialization he is able to produce 4 more rice meals the next year.Poor friday can only produce the same amount of rice year after year and he just continues producing grape meals. For each year Crusoe spends producing Rice without specialization, he can produce 3 more rice meals the next year. For each year Friday produces Rice without specialization, he can produce 2 more rice meals the next year. Of course you could do these assumptions in all different ways, that is sort of the overarching point with regard to how these models are used.
nonetheless, I chose these assumptions specifically. First, output isn’t growing by some percentage rate of the previous years output because recall that in this model all factors of production are fully employed and constant. There is no investment here. Thus the growing returns are relative to the underlying stock of capital and land and are thus exponential relative to them. There is no reason to think exponentially accelerating returns are possible under these conditions. However, there is reason to suppose that applying all factors of production will lead to returns growing more quickly than just applying some percentage of your factors of production. This is why rice output is growing faster for Crusoe under specialization than without specialization.
Second, Friday does not only start out less efficient but he is also less efficient at expanding output. I made this assumption to show that if you move to increasing returns there is a case against specialization even if Friday starts out less efficient at producing rice and is always less efficient at producing rice even if he focuses on it. I didn’t do the analysis here because it was obvious, but if you had perverse specialization- that is Friday specializes in rice- Friday produces 3 more rice meals every year, leading to the least total rice output of all the cases.
There are a number of interesting things here to say. This does a good job of making Cameron Murray’s point, which I’ve agreed with ever since I took a look at “Robinson Crusoe’s Economic Man”, that the Robinson Crusoe story is a great pedagogical tool for getting across a number of important concepts in economics. Here we have not only increasing returns and time but Baumol’s cost disease, inequality/distribution and intertemporal optimization. Relative prices are shifting in this economy because of labor productivity increases that exist in one good but don’t exist in another. Within an economy, those working in the low/no productivity growth sectors get wage increases to induce them to do these jobs. Hence the “cost disease” is the rising prices in these industries. This example clearly and easily expresses that idea. On the flip side, in other social contexts there may be no inherent reason for productivity increases to be shared.
If I felt particularly inclined to troll economists, I’d say that what they ignore in their arguments over comparative advantage is intertemporal optimization. That is a bit of a dig but it does get at an important truth. At each Individual point the traditional argument for comparative advantage applies. In fact, the gains to trade as conventionally measured are growing along with Crusoe's labor productivity! Yet taken together this is wildly suboptimal. The argument for protectionism in a very real sense has for a long time been about intertemporally increasing output by inducing production and investment decisions that seem perverse given current production possibilities and prices. The model also makes the important point that protectionism doesn’t have to ever give the protected country's protected industries absolute advantages in producing output over other countries for there to be an intertemporal maximization (or at least improvement) case for protectionism.
Then there is the issue of distribution which increasing returns under specialization brings to mind. If Robinson Crusoe and Friday were more conflictual, say because of property rights or because they represent different countries, in the specialization case Crusoe may not share any gains at all. After all Friday was gaining from specialization in the first year and should be willing to specialize for that benefit 25 years later. Of course the cost of not specializing to Crusoe is increasing all the time precisely because of his productivity increases. If the opportunity cost of not specializing for Friday was lowered by some probability of Crusoe giving in and sharing gains not specializing could be an optimal strategy for Friday for a sustained period of time. That is Friday may be well positioned to strike for higher wages and this example could be a case where striking improved overall welfare. After all economists typically say there is declining marginal utility to more of the same kind of output.
I hope you found this as interesting and entertaining as I did. I suspect that the different ways you can use the Robinson Crusoe story to express concepts in economics will become a running series on this blog.