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Means of exchange and prices

Money has been defined as the means of exchange. Basically, money is simply the intermediary facilitating the exchange of goods or services A for goods or services B. But there is another way to look at money from a quantitative point of view. Ugambo exchanged one goat for two baskets of apples. This means that in that specific economic transaction the transaction ratio of goats to baskets of apples is one to two. In other words, the "price" of one goat was two baskets of apples. The reverse is also true. In that transaction the "price" of two baskets of apples was one goat.

Now let's take a look at the same transaction but using silver coins. Ugambo exchanged his goat for 10 silver coins and then he exchanged those 10 silver coins for 2 baskets of apples. As you can see, the exchange ratio of goats to baskets of apples remained the same; this is 1 to 2. The fact that Ugambo used silver coins did not affect the "price" of the transaction. In a similar manner, we can think of those 10 silver coins as the transaction ratio of the first half of the transaction. What this means is that one goat was exchanged for 10 silver coins. The transaction ratio of goats to silver coins is 10. And that's it! The fact that Ugambo is using a widely accepted commodity (i.e. Silver) has nothing to do with the exchange ratio. What this means is that "price" is simply shorthand for "exchange ratio". Price does not have any other interpretation or definition beyond and exchange ratio.

Value in money

This is a subject that keeps confusing people. Let's begin by stating that yes, money has value but as any other good and service its value is purely subjective. We can accumulate value by storing sound money (e.g. gold or silver) but we can never know how much value we have accumulated because its exact value will only be revealed once we spend it. And its value will be quantified at that time and for that transaction only in terms of the goods or services we acquire. For example, trying to determine the exact value of one gold coin makes no sense since it is unspent. If, on the other hand, we exchange (i.e. spend) that one gold coin for a dress, then the value of that gold coin for that particular transaction is one dress.

It is true that we can calculate how much gold we may have in terms of gold grams, but this number only describes a physical property of the gold we have in our possession. It can never describe what we are going to buy with it (i.e. its true value) until we do so.

This value is entirely different from the physical quantity that may be required to achieve a specific technical goal. For example, if we wish to build a house we will require a specific amount of wood. The ratio between one house and the amount of required wood is known and can be counted. However, this does not mean that the quantity of wood has any specific value (in Praxeological terms) regarding the house.

The relationship between physical quantities in a technological process is not an exchange ratio. It is a technical ratio required to achieve a certain technical goal. If you want to build a house you will need a certain amount of wood. There is a ratio of house to wood but this ratio is not a price (i.e. not a value).

Fulfilment of needs

Although we can know ahead of time how much wood we will need to build a certain house and given a specific house this ratio will never change anywhere in the world, this ratio tells us nothing in terms of helping us to determine if we should build the house in the first place.

If we need or want a house, we have an uneasiness we want to eliminate. During the process of trying to satisfy our goal we will make value decisions regarding the house and the amount of required wood. But these decisions will be personal and subjective. For some people the amount of required wood will be too much and for other people it will be OK. Every person is different and will take their own decision for different reasons. The ratio hose to wood did not change, but the decision whether to build it or not, did.

What we want to know is how best spend our "wealth" (i.e. accumulated value) in order to best satisfy our more urgent needs. We may know that if we want that house we will need a specific amount of wood. But this ratio tells us nothing regarding what will satisfy our needs better; to buy that house or to buy a boat.

Furthermore, it is obvious that if we purchase the house we will spend more of our accumulated value than if we purchase the boat. But if we do so, is our wealth well spent? Will we be spending our wealth in the most effective way to decrease our uneasiness? Because once we buy the house, our wealth is spent. The ratio of house to wood cannot help us to make this determination.

Economic Calculation

In order to answer this question we need to be able to calculate how much of our wealth we are spending in one decision or another in a manner that is comparable. For example let's say that buying a house will cost us 20 cows, but buying a boat will cost us 10 orange trees and one dog. Which choice is more expensive? Or, in other words, is removing our uneasiness for lack of a house worth 20 cows when removing our uneasiness for lack of a boat is worth 10 orange trees and one dog? We don't know and we cannot know because it is not an exchange, it is an option. What will bring us more fulfilment for the price of 20 cows or 10 orange trees and one dog? A house or a boat?

In order to answer this question we need a way to compare the costs of two or more items on the basis of a common unit of measure. If we now know that buying a house will costs us 100 gold coins while buying a boat will costs us only 20, we can easily decide if it is worth for us, for our goals to spend 100 gold coins or it is too much and 20 is sufficient.

Furthermore, knowing how many gold coins we spent will allow us to plan for the future, for example for our retirement. Or perhaps it will push us to get a second job. It will also allow us to have a personal estimate as to how much wealth we have left and what can we do with it. All these mental processes are called economic calculations and are all based on the fact that all goods and services can now be measured in prices.

However, we must be very careful. These calculations are merely personal estimates based on past market prices and assumptions as to future market prices. As every price in every transaction is personal and subjective, prices cannot be forecasted but they can be estimated. These estimates are mental tools for economic planning. What this means is that in order for us to be able to perform economic planning (i.e. to estimate the most effective use of our resources to eliminate uneasiness) we need prices and this means that we need money.

Without money there can be no unified pricing system (i.e. a universal means of exchange) and without these prices there can be no economic calculation. Money is the vehicle of economic calculation and as such it is an inherent property of money. We cannot separate one from the other.

With money we can calculate (or estimate) capital and income (accumulated value and incoming value), profit and loss (changes in accumulated value), spending versus saving (using or saving accumulated value), cost and yield (exchange ratio for goods and services and future earnings on exchanged value) and so on. As you can see, although we can calculate quite accurately how much money is involved in these processes, we can only estimate what their value will be in the future because value is subjective and forever changing.

Efficiency

What prices allow us to do is to determine what will satisfy our needs more efficiently. If we are manufacturing a gadget and have the option of producing gadget A or B, we will choose whichever one will give us the highest profit (i.e. the most efficient allocation of resources). But there is a different way to look at the same process. If gadget B will give us the highest profit, this means several things. The first one is that we are using whatever resources we have in the most efficient way in order to minimize manufacturing costs. The second is that if the gadget can command a higher price, there is people out there that want that gadget sufficiently to pay a higher price. In other words, there are people for whom getting that gadget is high in their value list. That gadget is a priority to be satisfied for them.

By performing an economic calculation we can make sure that however few resources we have, we used them as efficiently as possible to satisfy other people's needs starting with their highest priority. Economic calculation allows the determination of people's most urgent need and the most effective means to satisfy this need all based on our own need!

Limits of economic calculation

Economic calculations cannot provide the answer to everything because for an economic calculation to be possible we need prices. If something has no price then economic calculations cannot be achieved. What this means is that we cannot use economic calculations to help us make decisions about something that cannot be sold or bought for example feelings or honour or valour or virtue or glory and so on. They are simply ends or goods of the first order (i.e. non-exchangeable consumer goods). For as long as people cannot purchase such characteristics, there is no market for them and therefore there is no price.

However, this does not mean that there isn't a choice to be made. For example, our apartment on the top floor of the building has a spectacular view of the city that we enjoy very much. A company offers us a sum of money to install a billboard in front of it thus blocking our view. We now need to make a decision as to what is more important to us, the money or the pleasure we get from the view. As the pleasure we get from the view cannot be assigned a price, economic calculations cannot help us with this decision. Thus, we are left with a simple and uncomplicated choice.

Information

At a more abstract level what prices provide is information. They tell us about the preferences of people and the scarcity of technical means necessary to create goods or services. This information allows us to be "economic" (i.e. more efficient) in selecting what will best satisfy our need with the minimum expenditure of our accumulated value. In order to do so, we use those prices in economic calculations which yield clear indications as to how to proceed. In ultimate analysis economic calculations are simply clear recommendations as to how to proceed based on your and other people's needs in a free market environment.

Note: please see the Glossary if you are unfamiliar with certain words.