Classical Theory of Value Determination - Research Paper Example

PATINKINS CRITIQUE OF THE ICAL THEORY OF PRICE DETERMINATION AND HIS PROPOSED REMEDY FOR ITS ALLEGED PROBLEMS. Overview to the ical Theoryof Value Determination A group of economists, called the quantity theorists, proposed the quantity theory which roughly says that in the long run the quantity of money and the general price level bear a proportional relationship, with money acting as the cause and the price level being the effect (Cottrell 1997, p.1). According to Cottrell, to identify the essentials of the theory a bit less roughly, we must consider the quantity equation in its standard modern form, MV = PY , which can be re-written as M/P = Y/V . It is not essential to the Quantity Theory that the ratio Y/V remain constant, in either the short run or the long run. The story of the Quantity Theory then runs like this: since V and T are fixed and M is exogenous, then an increase in the supply of money will lead to an exactly proportionate increase in the price level (Taylor 1996). As such, the price level is determined. Patinkin and his Criticisms on the Classical Theory of Value Determination Don Patinkin (1949, p.1) describes the general picture as to how classical economics works on how prices are determined: Classical economic theory postulates two parallel dichotomies: the real and monetary sectors of the economy on the one hand, and relative and absolute prices on the other hand. In the real sector all economic behavior depends solely on relative prices; conversely, once the behavior of the real sector is specified, relative prices are uniquely determined. Similarly, absolute prices play a role in and are determined alone by the monetary sector. Patinkin argues that the mistake lies in the fact that in a monetary economy a bridge is inevitably created between the real and monetary sectors: individuals cannot make decisions in the real sector independently of their decisions in the monetary sector. That is, people determine how much to supply of every good, they simultaneously determine how much money to demand (Patinkin 1949, p.1). Patinkin goes on saying that this idea is not novel to them but recognized and in fact made use of it. However, these economists, overlooked one of its simple implications, that is, if the supply of all goods depends only on relative prices, then of necessity, the demand for money can depend only on relative prices. Consequently, absolute prices will never exist in the system and hence cannot be obviously “determined” by it (Patinkin 1949, p.1). Patinkin summarised that the only way to have behavior in the monetary sector depend on absolute prices is to have these prices in the real sector. Conversely, if the real sector depends only on relative prices, then so must the monetary sector. Patinkin’s Criticism on Say’s Law Patinkin also cited that the classical school of economics frequently introducing the assumption of Say’s Law is a drawback to itself. In his work entitled “Law of Markets”, Jean-Baptiste Say claims that total demand in an economy cannot exceed or fall below total supply in that economy. . In James Mills’ words, "supply creates its own demand." In Say’s language, this would mean "products are paid for with products" (1803) or "a glut can take place only when there are too many means of production applied to one kind of product and not enough to another," (1803). As Say has stated it: It is worth while to remark, that a product is no sooner created, than it, from that instant, affords a market for other products to the full extent of its own value.   When the producer has put the finishing hand to his product, he is most anxious to sell it immediately, lest its value should diminish in his hands.  Nor is he less anxious to dispose of the money he may get for it; for the value of money is also perishable.  But the only way of getting rid of money is in the purchase of some product or other.  Thus the mere circumstance of creation of one product immediately opens a vent for other products (Say 1803, p.138-139). Patinkin recognizes that Say’s law served to remove other contradictions against the classical system but it did so at the expense of making it impossible to determine all prices (1949, p.1). According to Patinkin, the reason for this can be seen in the following manner: the meaning of Say’s law is that people spend all they receive, regardless of all prices. Thus, prices are seen to have no role in the monetary sector; consequently, the monetary sector can have no influence on the determination of prices. However, Patinkin reminds that the real sector, in itself, does not provide enough information to complete such task and that at most it can determine all but one of the prices as functions of the remaining one (Patinkin 1949, p.2). Also, Patinkin adds that if absolute prices are to be determinate, the classical system must be modified and noted that those modifications that do not completely break away from the classical dichotomy are doomed to fail (Patinkin 1949, p.2). According to Patinkin, the only way out of the difficulty the classical school is trapped is to discard completely the classical dichotomy between the real and monetary sectors, and to recognise that prices are to be determined in a truly general-equilibrium fashion, by both sectors simultaneously. However, Patinkin also quoted that nevertheless it is still quite possible to reconstruct the classical theory that the following familiar proposition still holds: an increase in the amount of money will merely cause a proportionate increase in the prices of all commodities, without in anyway affecting the demand and supply for these commodities, without in any way affecting the demand and supply for these commodities or the rate of interest (1949, p.2). Patinkin on the Mathematical Structure of Economic Theory Patinkin notes that when Walras and Pareto began their task of formalising economic theory into a rigorous, mathematical structure, having their systems contain two important criteria: (1) complete in the sense a specific value for each of the variables; and (2), consistent in the sense that there should exist a set of numbers for the variables that will satisfy simultaneously all the stipulated equations. To avoid inconsistency, they were careful not to impose more restrictions [represented by equations] than could be satisfied by the variables, that is the system should not be overdetermined (Patinkin 1949, p.2-3.) Patinkin provided the following example: Figure 1. An Assumed Market for Sugar provided by Patinkin (1949) Source: Patinkin (1949, p.3) Consider the market for sugar, and assume that the theory states that the amount of sugar demanded (x) is a function of its price (p), i.e., (1) x = D(p) If this were the extent of our classical economic theory, according to Patinkin, we should have an underdetermined system. That is, the price and quantity could correspond to any one of the infinite number of points lying on the curve D(p) in Figure 1. If we went on to postulate a supply function (2) x = S(p), then the price and quantity would definitely be established at (p0, x0), since this is the only point satisfying both the first two equations. If in addition we should state that the government fixes the price at (3) p = p1, we should have an inconsistent system. For by postulating (1)-(3), according to Patinkin, we are in effect saying that there exists at least one set of values for p and x that will simultaneously meet (1)-(3); but from Figure 1, it is clear that such a set cannot exist, hence the inconsistency (1949, p.3-4). Patinkin’s Remedy for the Classical Economic Theory According to Patinkin (1949, p. 23), there is a straightforward solution that can be formulated to save the classical economic theory. Patinkin writes that the key to the problem lies in distinguishing between two assumptions of classical monetary theory, which have hitherto been lumped altogether. The first postulates a twofold dichotomy between relative and absolute prices on the one hand, and the real and monetary sectors on the other. The second holds that the quantity of money has no effect on the determination of the equilibrium flows of goods and services. According to Patinkin, this last assumption is as basic and intuitively apparent today as it was in the “classical” times. Patinkin quoted that this is equivalent to the proposition that no difference will be made for the functioning of the economy if the dollar is replaced throughout by the peso. These inconsistencies and inadequacies, Patinkin says are due entirely to these assumptions (1949, p.23). Patinkin continues that the usual confusion of these two assumptions arises from the fact that in the classical system, the first is made as a means of implying the second. As such, the classical tradition failed to differentiate the two. To solve this, Patinkin suggests that the absolute price must be incorporated into every equation into the system, which then eliminates the dichotomies. Particularly, he argues that the excess demand function depends on the money value of these assets divided by the absolute price level. The modified classical system will now make use of the following variables: rate of interest, absolute price level, real national income, amount of money, and money value of all other assets. Patinkin’s analysis of earlier works by classical mathematical theorists also brought him to conclude that classical tradition is caught in two horns in a dilemma, that is, if the monetary equation is useful [in determining absolute prices], then it is inconsistent with the system. Reversely, if it is consistent with the system, then it is useless. The removal of the overdeterminancy of the system by virtue of Say’s law proves to be of no help as it simultaneously (1949, p.22). In light of these conclusions, Patinkin summarises that the following implications can be derived: the classical theory never dealt with the monetary aspects of the economy. Analysis under the classical tradition was limited to understanding the those aspects of the economy similar to a barter economy or at most an economy in which transactions take place with goods against goods, with money only acting as a counting unit. It did not explain why people hold cash balances (1949, p.22). Although various economists had criticized the separation of the theory of value and monetary theory, it was D. Patinkin who integrated these theories, in a way which could explain the determination of both absolute and relative prices. He used the real balance effect, which he incorporated into Walras’ theory of general economic equilibrium. The real balance effect represented a new element from which economic subjects derive utility. It is a specific case of the effect of wealth, which reflects influences on real variables caused by a change of wealth. Real money balances are the amounts of money, which individual economic entities leave in their possession. Their size is relatively stable. Economic entities use them to secure current transactions and to cover possible unforeseeable events. If real money balances are higher than desired and relatively stable in the long-term, economic entities will increase consumption. On the other hand, if they are lower than desired, consumption is reduced. It is necessary to realize that in this case, he did not consider the nominal sum of money possessed by the economic entity to be decisive, but whether this sum was sufficient to secure stable purchasing power. If the balance is disturbed, economic entities will make an effort to regain a balanced situation. Thus, the real balance effect becomes an important transmission mechanism, which joins individual markets. If the influence of real money balances on consumption is recognized, then they can be understood as an important factor influencing the development of aggregate expenditures, and as a factor, which works automatically. This enables us to conclude that the market mechanism has self-regulating strengths capable of automatically renewing balance (Profiles of World Economists 2003, p.24). Reference List Patinkin, D 1948, ‘Relative Prices, Say’s Law and the Demand for Money’, Econometrica, Journal of the Economic Society, vol. 16, no. 2, pp. 135-154. Patinkin, D 1949, ‘The Indeterminancy of Absolute Prices in Classical Economic Theory’, Econometrica, Journal of the Economic Society, vol. 17, no. 1, pp. 1-27. Cottrell, A 1997, Monetary Endogeneity and the Quantity Theory: The Case of Commodity Money. (www.wfu.edu/~cottrell/commodit.pdf) Leeson, R 1998, Patinkin, Johnson and “The Shadow of Friedman”, Working Paper No. 167. (http://www.mbs.murdoch.edu.au/workingpapers/167.html) Menger, C 1998, ‘The Theory of Value’, Principles of Economics (http://mason.gmu.edu/~tlidderd/menger/menger_ch3.html) Milios, J 2002, Theory of Value and Money. (ricardo.ecn.wfu.edu/~cottrell/ope/archive/0301/0029.html) Read More