Procrustean Art of Backtracking: “Price as Independent Variable”

 

Opening any textbook on Principles of Economics, we see the diagram of market with the price (p) on the abscissa and the quantity traded (q) on the ordinate. Further:

1)     The demand representing the marginal utility in the currency unit slopes downward.

2)     The supply representing the marginal production cost in the dollar slopes upward.

3)     There surely is a cross near the right end of the diagram.

4)     There we go, the equilibrium price (p*) and quantity (q*).

Easier than eating the cake (and having it too)!

             Don’t get it wrong. The framework simply is a metaphor; the metaphor by definition is not reality. In addition, the equilibrium price and the quantity traded can be known ex post. 

            The market never really works as per the textbook description. The typical demand or supply function as p= aq+ b is far from realistic; we already know that the demand and supply schedules are discrete in quantity and currency unit. At any rate, such a “nicely differentiable” function calls the quantity “the cause” and the price “the effect.” Again, the price is the dependent variable according to the classical metaphor.

Case #1. Macroeconomists have a super-strong trust is quantities and that in “real.” First of all, they define value-free GDP in “real quantity,” depriving the utility value of “the Market Value of All Final Goods and Services Produced Within a Country In a Given Period of Time” (Gregory Mankiw, Principles of Economics). Afterwards, they play with “real variables” such as Y, S, C, I, G, NX and r for the purpose suggesting “a model of several interacting markets” and many more.   

             Amongst the rest of us, such a practice is surreal if not “in name only.” We never buy the apple for physical quantity, but for its effectiveness in gratifying our wants.         

             Shh, they’ve got confused between the end (value) and a means (quantity).

Case #2. On one hand, la raison d'etre of Cambridge macroeconomics is prescribing policies to smooth out cyclicality of the economy over a year or so, also called “the short run.” On the other hand, they assume for the sake of building the IS-LM model that the price level (P) be “sticky” or otherwise “constant”: that is, P= P* in “the short run.”

             “See, I told you so”: We can now calculate the real GDP per annum, that is, the nominal GDP/ P* and the like. Take the real GDP of the US in 2020 for example. There is only one nominal GDP certified by the national income accountants as CPAs. May the economy be cyclical, the price level has been smoothened by the central bank, again P= P*. With P “constant” over the short run, all the other variables would be “more constant”!  

            Hurray!

Case #3. Enter the AS-AD model. Macroeconomists have “Pride and Prejudice” as regards the slopes of curves: the AD downward and the AS upward. As of this day, there does not seem to be a macro-agreement why so.

             Nevertheless, the rest of us can give such ready-made answers for the sake of their convenience. On the debit side, the AD curve slopes downward because the price level (P, not P*) is the opportunity cost of aggregately demanding for GDP. On the credit side, the AS goes upward because the price level is the opportunity benefit of aggregately supplying.  

            Wondrous except for reverse causation!

Case #4. Enter the “so many” General Equilibrium Models. According to Benjamin Franklin, when the economy in “equilibrium” finishes “varying,” it is finished.

             RIP!