THIS IS FALSE UNLESS PROVEN TRUE.
4. ALLOCATION
6.1 The Law of Value
The task of the theory of value is to explain how the law of value works, so that the seller is enabled to receive a payment of the same value as that of the good sold by the seller. It is the study of prices and outputs per period of production.
The market value [v=p*q] of an object of exchange is a quantity counted in a synthetic unit of accounting. It is a physical quantity q multiplied by a nominal price p, where the nominal price is the number of units of a reference good. The theory of value must explain both the quantity of output and the price.
The allocation model provides sound theoretical analysis of the determination of demand and supply at the individual level. It must assume given prices and incomes (or endowments) and apply the equilibrium condition demand = supply to determine output
Previous paradigms supposed that the equality of demand and supply would also determine the price. Unable to accept this view, consistent economics conducts a fresh investigation and finds three major issues in which new concepts are used to reach new conclusions. These issues are: (1) price determination, (2) output decomposition, and (3) profit and loss in equilibrium.
6.1.1 Theory of Price
The equality of demand and supply determines the quantity, but not the price. To determine price, the equivalence condition is applied to impose the income/endowments restrictions on top of the [demand =
supply] condition. The price-setting process requires arbitrage and allows the price to leave room for positive profit for the seller and positive benefit (utility gains) for the buyer. It allows an equilibrium in which
marginal cost < price < marginal benefit 6.1.2 Decomposition of Aggregate Output
The equality of aggregate demand and aggregate supply is derived in successive steps. It begins with (1) the equality of values for each transaction, then moves to (2) the budget balance of each agent or sector through the use of money, and lastly looks at (3) the overall budget balance of all sectors through the use of money and bonds to exchange current surpluses over current expenses. This means that aggregate output depends on the structure of payment including money and bonds.
6.1.3 Measuring Profit and Loss
The formulation of the market equilibrium must leave room for positive profits and risks of loss due to any failure in trade. This part affects the analysis of the equilibrium between investments and savings in a dynamic setting. This is built on the concept of market price set by entrepreneurs who bear risks and attempt to get a profitable price.
6.2 Theory of Output (or Income)
The task of the theory of output is to describe and explain how the quantity of output is determined. Prevailing microeconomics provides a solid theory of the determination of output at the micro level. The gist: the quantity of output is determined by the equality of demand and supply.
However, the individual demands and supplies themselves depend on the prices and incomes (or factor endowments). The market equilibrium must determine the quantities, prices, and incomes together. The allocation model cannot put incomes, prices, and quantities together as endogenous variables. The level of aggregate output cannot be determined without considering these factors.
The issues may be clarified by considering the determination of output under autarky and then introduce direct and indirect exchange to see how the equilibrium configuration changes.
6.2.1 Output under Subsistence
Chapter 4 has shown that under subsistence, output is determined by the equilibrium condition where [consumption=production]. It occurs at a level of output where the marginal rate of substitution in consumption is equal to the marginal rate of substitution in production. By simple addition of individual output, once can get aggregate output. There is no need for a separate macroeconomics under subsistence.
6.2.2 Output under Trade
It is important to recognize that the presence of agreements, various means of payments, and of intermediaries under trade gives rise to economic phenomena that cannot occur under subsistence. They include involuntary unemployment, undue instability driven by prices and payments, and unintended debt, all with impact on output. None of these phenomena can be visualized at the individual level under subsistence. Had these phenomena been tractable at the individual level, there would be no need for macroeconomics.
Consider barter between Crusoe and Defoe. Using the notation for exchanged goods, let xCD be the quantity of fruits sold by Crusoe to Defoe, xDCbe the quantity of grains sold by Defoe to Crusoe. Let xCCand xDD stand for the subsistence output of fruits and grains produced and consumed by Crusoe and Defoe respectively. Then the output under barter can be described by the matrix
Would the bartered output (xCD, xDC) be produced under subsistence? There are two parts to the answer.
z The first is allocational efficiency.
z The second is the expansion of capacity utilization.
6.2.2.1 Allocational Efficiency:
If there was no trade, Crusoe could not buy xDCof grains from Defoe, and would have to produce grains himself. He would have to reduce the output of fruits to release inputs from the production of fruit to the
production of grains. For approximate measurement, we may suppose that Crusoe would reduce fruit output by the amount xCD, and keep the output of fruits at xCC. The graph below shows that there is a deadweight loss of output measured in G equal to (Gc-G*). Crusoe would reduce fruit output to Fa, which is smaller by (Fa-Fc) than xCD. A large part of
the output (Fb-Fa) would not be produced.
The important point is that Crusoe can produce merely (G*-Gb) by
reallocation of factors with net loss of grain output measured by (Gc-G*).
Thus, output under trade is larger than under subsistence owing to greater allocational efficiency.
6.2.2.2 Expansion of Capacity Utilization
The much larger impact of trade on output occurs by way of an expansion of capacity utilization. This includes bringing under use formerly unused natural and human resources. However, we have not found a neat formal analysis to measure this impact in the abstract. It shows up in comparative statistics on output before and after trade.
In the post-industrial economy, output is largely dominated by services. Most services are by their very nature tailored to serve customers, and are rarely open to consumption by the service provider. It is difficult, for example, to see how a receptionist or neurosurgeon or journalist or consultant or a commercial pilot or a teacher or entertainer can use much of the service for one's own consumption.
6 Value 137 138 Foundations of Economic Science
xCC xCD xDC xDD
Most individuals in the post-industrial economy no longer possess the natural resources to produce food or other material things. It then becomes clear how a high degree of professional specialization creates the preconditions for involuntary unemployment.
Under autarky, involuntary unemployment is absent Indeed, people in subsistence economies cannot even imagine such a situation and would not have a term for it. (See Wasow 1976). The previous literature on unemployment did not see this structural factor. Say's Law implicitly presumes that what cannot be sold is consumed by the producer. Unemployment occurs if what cannot be sold, cannot be produced.
6.2.2.3 Output under Indirect Trade
Under indirect trade, money is necessary to enable buyers to pay the sellers, as explained in the next chapter. The presence or absence of money affects the demands through the effects on the ability to pay. A decomposition of output according to the means of payment reveals how the level of output depends on the structure of payments. (See the next chapter).