| Question Bank (related to but not directly from this article, and some parts are relevant to a video in the section on Real and Nominal Prices) |
Prices and markets
A price is the cost one pays for something. Sometimes the price can be set by governments or tradition, but most of the time, when economists speak of prices they are referring to the result of a voluntary negotiation between a buyer and seller, dictating the terms-of-trade. Most of the time, these terms stipulate how much of a currency a buyer must give to the seller to acquire whatever good or service they provide. When economists think of prices, they are usually referring to prices set in markets. Before we really investigate how prices are set, we must first distinguish nominal from real prices, for when the non-economist thinks of prices they usually refer to the nominal kind, whereas economists are thinking of the latter. It is also useful at this point to have a good understanding of what a market is, and I find that both of these objectives can be achieved by thinking about the market for food in a POW camp during World War II. What follows is a true story.
Real prices in a POW camp market
Radford was a prisoner-of-war (POW) during World War II, spending most of his time within one company of 200 prisoners. Rations were provided to them by the Red Cross, and given to each individual in identical food parcels. Among the food items were tinned milk, jam, butter, biscuits, bully, chocolate, sugar, and importantly, cigarettes. The parcels given to each individual was the same, but of course, not every prisoner had the same tastes.
Although certainly appreciative of their parcels, the prisoners sought to improve their food rations by trading the foods they liked the least for foods they liked the most. Fortunately, differences in tastes allowed hundreds of mutually beneficial trades to occur. With every trade, both individuals were better off— else they would not have traded.
Video 1—Hear a World War II POW Express His Gratitude
for Red Cross Rations
At first they traded through barter, where someone who wanted to trade biscuits for chocolate must find someone who wanted to trade chocolate for biscuits. This is referred to as a double-coincidence-of-wants, which naturally made trading rather inefficient. Imagine if you did not have money, but instead had to barter for everything you needed. For me, I to acquire chicken I would have to find someone who both had a chicken and was willing to trade it for economic lectures. I would probably starve! However, this wasn't that difficult in the the POW camp, because the number of goods was limited and were highly valued by most everyone. If you wished to trade biscuits for chocolate it wasn't that difficult to find someone who would trade with you.
The amount of one food that was traded for another—say, three biscuits for one chocolate—represents real prices. A real price is an amount of one good that must be given to acquire another good. If three biscuits does consistently trade for one chocolate, then the price of biscuits is 1/3 chocolate and the price of chocolate is 3 biscuits. Because there were numerous food items any good could be stated in terms of many real prices. One chocolate may cost 3 biscuits or two butters. Both of these are real prices. In a modern economy with millions of goods, we usually state the real price of a good in terms of the number of "baskets" that good could be traded for in a market (traded not by barter, but with money), where each basket represents a typical profile of goods and services the average American consumes.
Nominal prices in a POW camp market
The prisoners eventually realized the hassle involved with trading, and a form of money emerged to avoid the double-coincidence-of-wants. Because cigarettes were valued by almost all prisoners, storable, identical, and easily portable, cigarettes became the official currency in the camp. Now, to trade biscuits for chocolate one only had to find someone who would pay cigarettes for your biscuits (which was easy, since everyone had cigarettes) and another person who would accept cigarettes for chocolate (which was easy, since everyone wanted cigarettes). At first, a prisoner would wander through camp announcing offers like, "cheese for seven" (cigarettes), but eventually they adopted a central market where prisoners would post on a board their name, room number, an item they wished to buy with the price (number of cigarettes) they would pay, and/or offers to sell a food at a certain price.
Cigarettes were both a good and a form of money. Prisoners used cigarettes to buy and sell things, but they also smoked them. For this reason cigarettes were a form of commodity money in that it had an intrinsic value separate from its use as money.
These prices that emerged were nominal prices and real prices at the same time, because each good was stated in terms of a common currently, and because cigarrettes were also a good they could consume. However, we will refer to these prices solely as nominal prices. When the supply of cigarrettes rose inflation would occur, just like it would if the U.S. Federal Reserve prints money. Deflation (a fall in prices) could result if the supply of cigarrettes fell. However, if the supply of cigarrettes changes but the supply of other food items did not, we would see fluctuations in the nominal prices but not necessarily real prices. One chocolate may still be worth three biscuits, regardless of whether the price of chocolate and biscuits are six and two, respectively, or twelve and four.
Video 2—Red Cross Rations in Movie Stalag 17(S1)
(must use Internet Explorer)
The POW camp and the MV = PQ equation
A previous selection of articles and videos used the Quantity Theory of Money (that is, the MV = PQ equation) to illustrate how nominal prices are formed. If the POW camp is our economy, this equation takes a far more tangible form. The variable "Q" was defined as a basket of goods and services the typical person consumes. In the POW camp this basket could be a single food parcel and the tinned milk, jam, butter, biscuits, bully, chocolate, and anything else the parcels contained. More parcels constitute a higher Q, which for us is like greater wealth. The P variable refers to the price of a basket, which in this case would be the number of cigarettes requires to purchase all the food items a single parcel contains.
Distinguishing nominal and real prices
The prices you see in stores, catalogs, and website are nominal prices, yet because it is the amount of goods and services we can consume that is important, we must learn to discern whether a nominal price changes simply due to inflation or due to a change in real prices.
For example, throughout your working life you will receive promotions and raises. Inflation will likely continue also, and whether those raises actually give you more spending power determines whether your employer is really rewarding you or not.
College graduates are often offered jobs in different locations. I once had a student offered a job in Oklahoma City and New York city. The job in New York provided her with a much higher nominal salary, but once she took into account differences in prices between the two regions, she realized New York was actually offering her a lower real price for her labor.
Your abiliy to borrow money to buy a house and save money for retirement depends on interest rates, and because interest is simply the price of lending/borrowing money, it also has a nominal and real component. Understanding the difference between nominal and real interest rates is absolutely essential if you are to manage your household's finances prudently.
The articles in this section all seek to help you determine whether changes in nominal prices result in higher or lower real prices, something every student taking an introduction to economics course should learn.
