LATEX

LATEX

Saturday, February 27, 2016

Value & Capital, CHAPTER V, Section 6

In this section Hicks begins to lay out his explanation of how economic laws can be derived from the stability conditions for a system of exchange.  He starts by supposing that some of the persons trading experience an increased desire for one of the commodities.  He explains that they are prepared to satisfy this desire by "increasing their supply (or diminishing their demand) for the standard commodity" while leaving their demands and supplies for all other commodities unaffected.  (To be clear, he's talking about increasing their supply of the standard commodity to the market, not increasing their own reserves of the commodity.)  He then asks what changes in prices should result.  To get at this answer he notes that the changes must cause an increase in supply from the other traders that would be sufficient to match the increase in demand from the first group.  The stability conditions have already specified what changes in prices will lead to an excess supply:  to increase the supply of a good X, its price must be raised.

What about the effects on other prices?  If we ignore income effects, and if we can assume that market reactions only take place for one other good Y, then the effect of the increased demand for X on the price of Y follows from the same analysis as shown in section 4:  the price will increase if X and Y are substitutes and fall if they are complementary.  Only this kind of change will maintain equilibrium in the Y-market.

Things get more interesting if more than one other price is affected.  Hicks runs through several possibilities, including the following:  "If Z is a substitute for X, the price of Z will be raised [by the increased demand for X]; and if Y is also a substitute for Z, this in its turn will raise the price of Y."  Also, "if Z is complementary with and a substitute for Y, the effect through the Z-market will be to lower the price of Y."  He summarizes these cases as follows:
Indirect effects through third markets thus obey the rule that an increased demand for X will raise the prices of those goods which are substitutes of substitutes, or complements of complements, for X; it will lower the prices of those goods which are complements of substitutes, or substitutes of complements.
In cases where there are more commodities and prices involved, multiple indirect effects may be significant.  "Sometimes, perhaps often, they will all go in the same direction," Hicks states, giving the example where X and Y are part of a group of goods that are all substitutes for each other.  When X and Y are members of a group of goods that are all complements, however, things are more complicated;  the direct effect would be to lower the price of Y, but due to indirect effects, the net effect on the price of Y could go in either direction.

According to Hicks, "A system of multiple exchange in which no complementarity was present at all would obey a simple rule.  However many indirect effects were allowed for, they would all go in the same direction."  In addition, an increase in the demand for X would raise the price of X;  it would also raise the prices of all the other goods, but proportionately less than the price of X.  Hicks states that "Complete absence of complementarity, in this manner, is of course not at all a probable condition," but he places an interesting footnote here, in which he points out that the case of international currency exchange is an example where this property may be realized approximately.  "To the foreign-exchange dealers, bills in various currencies are probably all substitutes for one another."

Hicks spends the next-to-last paragraph of this section arguing that many actual situations can be expected to approximate the situation of complete absence of complementarity.  He states that in taking two goods at random, we would more likely expect them to be substitutes than complements.  In addition, indirect effects of complementarity tend to neutralize the direct effects.

Hicks's conclusion to this section's discussion is that "it does appear that an increase in demand for a particular good (or group of goods) is most likely to have an upward effect upon prices in general."  Due to indirect effects, it's possible that some goods that are directly or indirectly complementary with the one whose demand increased could have their prices fall, but these would be the exception.  In addition, the general upward effect on prices will not be widespread unless the good or goods whose price increased were "of considerable importance."

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