Real prices and ideal prices
Encyclopedia
Real prices and ideal prices refers to a distinction between actual prices paid for products, services, assets and labour (the money that actually changes hands), and computed prices which are not actually charged or paid in market trade, although they may facilitate trade. The difference is between actual prices paid, and information about possible, potential or likely prices, or "average" price levels.

Ideal prices, expressed in money-units, can be "estimated", "theorized" or "imputed" for accounting, trading, marketing or calculation purposes, for example using the law of averages
Law of averages
The law of averages is a lay term used to express a belief that outcomes of a random event will "even out" within a small sample.As invoked in everyday life, the "law" usually reflects bad statistics or wishful thinking rather than any mathematical principle...

. Even if such prices therefore may not directly correspond to transactions involving actually traded products, assets or services, they can nevertheless provide "price signal
Price signal
A price signal is a message sent to consumers and producers in the form of a price charged for a commodity; this is seen as indicating a signal for producers to increase supplies and/or consumers to reduce demand.- Free price system :...

s" which influence economic behavior.

For example, if statisticians publish aggregated price estimates about the economy as a whole, market actors are likely to respond to this price information, even if it is far from exact, based on a very large number of assumptions, and later revised. The release of new GDP data, for instance, often has an immediate effect on stock market
Stock market
A stock market or equity market is a public entity for the trading of company stock and derivatives at an agreed price; these are securities listed on a stock exchange as well as those only traded privately.The size of the world stock market was estimated at about $36.6 trillion...

 activity, insofar as it is interpreted as an indicator of whether and how fast the market - and consequently the incomes generated by it - is growing or declining.

Ideal prices are typically prices that would apply in trade, if certain assumed conditions apply (and they may not). The distinction between real prices and ideal prices was first made theoretically explicit by Karl Marx
Karl Marx
Karl Heinrich Marx was a German philosopher, economist, sociologist, historian, journalist, and revolutionary socialist. His ideas played a significant role in the development of social science and the socialist political movement...

 in the first volume of Das Kapital
Das Kapital
Das Kapital, Kritik der politischen Ökonomie , by Karl Marx, is a critical analysis of capitalism as political economy, meant to reveal the economic laws of the capitalist mode of production, and how it was the precursor of the socialist mode of production.- Themes :In Capital: Critique of...

, chapter 3:
The activity of pricing goods, services and assets, facilitating transactions, communicating prices and keeping track of them in fact consumes a very large amount of human labour-time, irrespective of whether it happens to occur in a centralized or decentralized way. Millions of workers are professionally specialized in such activities, whether as clerks, tellers, buyers, retail assistants, accountants, financial advisors, bank workers, or economists etc. If that work is not done, price information would not be available, with the result that the trading process would become difficult or impossible to operate. Whether or not this is considered "bureaucratic", it therefore remains an essential administrative service. People cannot "choose between prices" if they don't even know what those prices are; and, normally, they cannot just "make up" any kind of price they like, because costing, budgets and incomes depend precisely on what price is charged.

The creation of price information is therefore a production process - its output is worth money, because it is vital for the purpose of trade, and without it the circulation of goods and services could not occur. Price information can therefore be bought and sold as a commodity as well. But the production process of prices themselves is often hidden from view and hardly noticeable. Therefore people often take the existence of price information for granted and as obvious, meriting no further inquiry. A price may also be attached in the course of another activity, or the pricing procedure may be a closely guarded secret rather than accessible in an open market
Open market
The term open market is used generally to refer to a situation close to free trade and in a more specific technical sense to interbank trade in securities.-Use of the term in economic theory:...

 because if competitors knew about it, this could adversely affect business income. But if pricing processes are viewed as production processes, it turns out that much more is involved than the observation of a price-tag or number might suggest.

Illustrations of ideal prices

  • An example of an ideal price would be the value of annual Gross Domestic Product
    Gross domestic product
    Gross domestic product refers to the market value of all final goods and services produced within a country in a given period. GDP per capita is often considered an indicator of a country's standard of living....

    . This aggregate price is an ideal price, derived through an accounting procedure from statistical observations of financial reports, using principles of value equivalence and comparability, conserved/transferred value, value reduction, value increase and newly created value. Included in this ideal aggregate price are many estimated and imputed prices reflecting the assumed monetary value of products and services. But there exist no real traded goods or services, or group of traded goods and services, to which that aggregate price exactly corresponds. At best one could say, that this estimated aggregate price reflects a sum of money that "would buy" a certain group of products, assets and services, under specific assumed conditions. In other words, such a price does not correspond directly to real financial flows
    Stock and flow
    Economics, business, accounting, and related fields often distinguish between quantities that are stocks and those that are flows. These differ in their units of measurement. A stock variable is measured at one specific time, and represents a quantity existing at that point in time , which may have...

    , but instead analytically groups components of those flows in order to make a valuation which corresponds to an economic concept, in this case value added
    Value added
    In economics, the difference between the sale price and the production cost of a product is the value added per unit. Summing value added per unit over all units sold is total value added. Total value added is equivalent to Revenue less Outside Purchases...

    .

  • Another example would be an equilibrium price calculated by an economist. This is a price which a type of product or asset would theoretically have, if supply and demand were balanced. This price does not exist in actual trading processes except in special and rare cases; it is only an ideal or theoretical price level, which at best is only approximated in the real world.

  • In accounting practice, ideal prices are used all the time. For example, when accountants have to value a stock of assets, or a set of transactions across an interval of time (for tax, commercial or audit purposes), they apply rules and criteria to arrive at a price reflecting the cost or market-value of the stock or flow of transactions. In grossing and netting, they apply certain rules of inclusion and exclusion to obtain the desired measure. But the valuation obtained following a standard procedure is in truth only hypothetical, because it represents a price which the assets or flows would have if they were traded or exchanged under assumed (stylized or standardized) conditions, or if they were replaced at a certain point in time. In principle, they need not refer to any real transaction flows at all, being only an imputation
    Imputation
    Imputation can refer to:*Imputation , the concept that ignorance of the law does not excuse*Imputation , substitution of some value for missing data*Imputation , estimation of unmeasured genotypes...

    . Yet, the ideal price obtained may nevertheless influence a whole lot of transactions based on it, to the extent that it provides information and a measure of how a related market process is thought to be evolving.

  • Ideal prices are often used in price negotiations, bidding, price estimation and insurance. These are calculated prices for things being traded, or the compensation which would be given, if certain conditions apply. Business deals can become very complex, and may involve numerous price assumptions. For example, the contract may be that if an average price trend occurs, then a certain amount of money will be paid out. Thus, the actual amount of money that changes hands may be conditional on a variety of price estimates.

Actual and potential prices

When goods are produced for sale, they may be priced, but those prices are initially only potential prices. There may not be any certainty about whether they will all fetch exactly the sum of money stated by those prices when they are actually sold, or whether they will be sold at all. In retrospect, the final value of an output, activity or asset may turn out to have been higher or lower than previously anticipated, because for various reasons prices and demand changed in the meantime. Thus, price negotiations, trading circumstances and the time factor may change actual prices realised from the prices originally set, and if price inflation occurs there is in addition a difference between the nominal prices and the inflation-adjusted price. The price of a stock or a debt security, expressed in a given currency, may be highly variable, and their variable yields may in turn revalue or devalue the prices of related assets.

Thus, the "price mechanism" is often not simply a function of supply and demand for a tradeable object, but of a structure of related and co-existing prices, where fluctuations in one group of prices impact on another group of prices - perhaps quite contrary to the wishes of buyers and sellers. In this sense, the concept of a "price shock" refers to a drastic change in the price of a good which is widely used, and which therefore suddenly changes a whole lot of related prices.

The sale price may be modified also by the difference in time between purchase and payment - for example, someone may opt to buy a product on credit, and pay interest in addition to the asking price for the product; and the interest charge may additionally vary during the interval in which the principal is paid off. Or, the price changes because of price inflation or because it is renegotiated. If it is not possible to pay for something within the previously expected time interval, that may also change prices.

Valuation criteria in pricing

Consequently, what the "real" price of a thing is, might be a topic of dispute, because it may involve conditions and valuation criteria which some would not accept, because they apply different valuation criteria, different conditions or have a different purpose. For example, an asset may be valued at:
  • its historic cost,
  • its book value
    Book value
    In accounting, book value or carrying value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or Impairment costs made against the asset. Traditionally, a company's book value...

    ,
  • its accounting value,
  • its current market value,
  • its nominal value,
  • its accrual value,
  • its discounted, sale or groupon value,
  • its value for legal purposes,
  • its gross or net value,
  • its current replacement value,
  • its current trading value,
  • its value given its current location,
  • its value before or after transport costs,
  • its transfer pricing
    Transfer pricing
    Transfer pricing refers to the setting, analysis, documentation, and adjustment of charges made between related parties for goods, services, or use of property . Transfer prices among components of an enterprise may be used to reflect allocation of resources among such components, or for other...

     value
  • its value in terms of its future earnings potential,
  • its insurance value,
  • its value for tax purposes
  • its pre-tax or post-tax value
  • its depreciated value,
  • its inflation-adjusted value,
  • its value given a risk of loss of value,
  • its value in a foreign currency,
  • its value at purchasing power parity
    Purchasing power parity
    In economics, purchasing power parity is a condition between countries where an amount of money has the same purchasing power in different countries. The prices of the goods between the countries would only reflect the exchange rates...

  • its final value,
  • its scrap value etc.


A price can be computed for each of these valuations, depending on one's purpose. Often the purpose is assumed to be self-evident, being related to a specific transaction, and thus what the price of something is, is taken as obvious. But an object or activity can in reality be priced in many different ways depending on what valuation is relevant, or what price is negotiated.

In most Western countries, prices in e.g. a grocery shop or supermarket are usually fixed and non-negotiable; but in other countries (e.g. Morocco) buyers and sellers often make time to negotiate an acceptable price. Computerized inventory and payment systems using bar codes or other standard product identification systems usually require fixed (standardized) prices, i.e. they cannot easily cope with the possibility that a seller decides (for example) to sell groups of products at different prices to different customers.

The number of ideal prices used for calculations or signalling in the world vastly exceeds the number of real prices fetched. At any point in time, most economic goods and services in society are being owned or used, but not traded; nevertheless people are constantly extrapolating prices which would apply if they were traded in markets or if they had to be replaced. Such price information is essential to estimate the possible incomes, budgetary implications or expenditures associated with a transaction.

The use of ideal prices for the purpose of accounting, estimation and theorising has become so habitual and ingrained in modern society, that they are frequently confused with the real prices actually realised in trade. Prices may be viewed only as a kind of data, information, or a type of knowledge, or the information available about a money quantity may be equated with the "real thing".

The knowledge of prices may have an effect influencing trading possibilities, which in turn changes the knowledge of prices. Consequently such knowledge is often kept confidential or is a business secret (see also information security
Information security
Information security means protecting information and information systems from unauthorized access, use, disclosure, disruption, modification, perusal, inspection, recording or destruction....

 and sociological aspects of secrecy).

Are prices exact?

Money-prices are numbers, and numbers can be computed with exactitude. This seems to make accounting and economics exact sciences. But in the real world, prices can change quickly, due to innumerable conditions and it may be that prices can only be estimated approximately for budgetary or contractual purposes. In aggregating them, a judgement is made about the meaning of the transactions involved, and boundaries are defined for where they begin and end. Consequently, in calculating price quantities, a value theory of some sort is usually applied, regardless of whether this is made explicit or not. And, typically, this value theory refers to prices which would apply under certain assumed (theoretical) conditions, moving between real prices and ideal prices.

Mathematics professor John Allen Paulos
John Allen Paulos
John Allen Paulos is a professor of mathematics at Temple University in Philadelphia who has gained fame as a writer and speaker on mathematics and the importance of mathematical literacy...

 at Temple University
Temple University
Temple University is a comprehensive public research university in Philadelphia, Pennsylvania, United States. Originally founded in 1884 by Dr. Russell Conwell, Temple University is among the nation's largest providers of professional education and prepares the largest body of professional...

 states the general problem encountered here clearly:
It may of course be that not "almost any desired outcome can be reached" in price calculations, insofar as one would have to deny relevant evidence. Nevertheless it may be that several different outcomes are possible, or that the presence of biases in interpreting price information can make a significant quantitative difference to the result (see further phenomenology (science)
Phenomenology (science)
The term phenomenology in science is used to describe a body of knowledge that relates empirical observations of phenomena to each other, in a way that is consistent with fundamental theory, but is not directly derived from theory. For example, we find the following definition in the Concise...

). Insofar as economic actors have a vested self-interest in a particular quantitative result, because their income is at stake, then there is the possibility that they will prefer "one sort of calculation" to another, because it yields a financial result that favours their own position. That financial result may be reasonably "credible" or "plausible" for the purpose of trading - if it was way out of kilter, trading partners would reject it - but it could involve a margin of distortion of the true situation. The small discrepancies would ordinarily not matter so much in individual transactions, but if a very large number of transactions is added up, the distortion might represent a substantial income for someone.

According to the brilliant mathematician Benoît Mandelbrot
Benoît Mandelbrot
Benoît B. Mandelbrot was a French American mathematician. Born in Poland, he moved to France with his family when he was a child...

, the beautiful simplicity of prices was that they have only one parameter defining their variability: they "can only go up or down" - and that, then, seems to provide a robust logical foundation for the mathematical modelling of price movements (see: John Authers, "Why 'efficient markets' collapse", video interview with Benoit Mandelbrot, in: Financial Times website, 30 September 2009). But this sidesteps the qualitative problem that many different prices can be calculated for the same good, for all kinds of different purposes, using different valuation assumptions or transaction conditions. Mandelbrot's idea already assumes that we have a standard way to measure prices. Given that standard, one can then perform all kinds of mathematical operations on price distributions. Yet tradeable objects can also be combined and repackaged in numerous different ways, in which case the referent price may not simply go up or down, but instead refers to a different kind of deal. This issue is wellknown to official statisticians and economic historians, because they face the problem that the very objects whose price movements they aim to track change qualitatively across time, which may necessitate adjustments of the classification systems used to provide standard measures. A good example of that is the regimen
Regimen
A regimen is a plan, a regulated course such as a diet, exercise or medical treatment, designed to give a positive result. A low-salt diet is a regimen. A course of penicillin is a regimen.- History :...

 of the consumer price index
Consumer price index
A consumer price index measures changes in the price level of consumer goods and services purchased by households. The CPI, in the United States is defined by the Bureau of Labor Statistics as "a measure of the average change over time in the prices paid by urban consumers for a market basket of...

, which is periodically revised. But in times of rapid social change
Social change
Social change refers to an alteration in the social order of a society. It may refer to the notion of social progress or sociocultural evolution, the philosophical idea that society moves forward by dialectical or evolutionary means. It may refer to a paradigmatic change in the socio-economic...

, the problem of devising a standard measure may be much more pervasive.

FASB and the epistemology of prices

The Financial Accounting Standards Board
Financial Accounting Standards Board
The Financial Accounting Standards Board is a private, not-for-profit organization whose primary purpose is to develop generally accepted accounting principles within the United States in the public's interest...

 http://www.fasb.org/home makes it very explicit that accounting measures for price information may not not be completely exact or fully accurate, and that they may not be completely verifiable or absolutely authoritative. They may only be an approximation or estimate of a state of affairs. A price aggregate may be made up from a very large number of transactions and prices which cannot all be individually checked, and the monetary value of which may involve a certain amount of interpretation. For example, a price may be set but we may not know for sure whether a good or asset actually traded at this price, or how far exactly the actual price paid diverged from the ordinary set price. However, the Board argues that, within certain acceptable limits of error, this is not a problem, so long as we bear in mind the practical purpose of the measures:

.

In other words, an approximate estimate of magnitudes may be sufficient, with a margin of error which can be statistically computed. Provided several measurers obtain the same result following a standard procedure, the price information can be trusted. If price information is challenged in a court of law, different authorities may be called on to provide evidence to show that the information is either true or false.

Bank
Bank
A bank is a financial institution that serves as a financial intermediary. The term "bank" may refer to one of several related types of entities:...

s normally ensure that accounting information about deposit accounts is absolutely exact (apart from the occasional, unintended bank error). If a bank would make errors in accounting for transactions, people would no longer trust the bank, and take their money elsewhere. With the aid of computers, errors can usually be prevented or else quickly identified; as against that, the more markets expand, the larger the total volume of transactions, which statistically means that the possibility of error increases. Technically it also means, that price information about large transaction volumes becomes highly dependent on the efficient functioning of computer technology, and if computer systems crash or the electricity supply lapses, it may be that large amounts of price data are suddenly not available anymore.

Quantitative accuracy is always of prime importance in the banking industry. Nevertheless, in their commercial policy, banks also use price information which is much more approximate or anecdotal, insofar as it refers to conditions which are "likely" or "probably the case" - there may be no readily available means of verification. To some extent, therefore, the banking industry also relies on trust that the price information provided is accurate and correct. If people's own money is at stake, they are of course highly motivated to ensure that this accuracy and trust is preserved. But usually there are also legally enforced rules governing trade. Already in the earliest states in societies where substantial trade occurred, the state appointed supervisory authorities to combat cheating
Cheating
Cheating refers to the breaking of rules to gain advantage in a competitive situation. The rules infringed may be explicit, or they may be from an unwritten code of conduct based on morality, ethics or custom, making the identification of cheating a subjective process. Cheating can refer...

 with measurements of traded goods and services, imposing legal penalties for fake measures. Nowadays, false measurement in trading practices is often considered a crime
Crime
Crime is the breach of rules or laws for which some governing authority can ultimately prescribe a conviction...

.

The economic calculation problem and prices

In the classic socialist calculation debate, the participants generally believed that economic calculation was a problem for centrally planned economies. Necessarily the central planners had to engage in price accounting, and had to use price information, but the volume and complexity of transactions was so great, that genuine central planning of the economy was often not really feasible in practice; often the state authority could only enforce the conditions of access to resources with the aid of extensive policing. An additional problem was, that much of the price information was actually false or inaccurate, because economic actors had no interest in providing truthful information, because the nominal price of goods did not reflect their value, or because goods changed hands informally in ways which could not be formally recorded and known. The effect was that the computed accounting information was often a mixture of fact and fiction.

However, on closer inspection market economies suffer from very similar defects, in the sense that much commercial price information is in practice deficient, false, distorted or inaccurate. This is not necessarily because trading parties intend to deceive, but simply because it is technically impossible to provide fully exact price information. Official price estimates often fail to be accurate and cannot be verified thoroughly, among other things because they rely on sample survey techniques or partial and infrequent information. Price signals are not intrinsically always clear; they can be deceptive, understating or overstating the real situation, or present a completely false picture of transactions and values. Jean-Claude Trichet
Jean-Claude Trichet
Jean-Claude Trichet is a French civil servant who was the president of the European Central Bank, a position he held from 2003 to 2011. He is also a member of the Board of Directors of the Bank for International Settlements...

 for example remarked in 2008 that:
A "unit of risk" does not really exist, but this category can nevertheless be thought of as the quantity of money which represents a "possible" financial loss. This can be formulated as a mathematical relationship between the magnitude of the value of an asset and the likelihood that a loss in its value of a certain size will occur, based on information from the past. We can then calculate an "average risk margin" for all kinds of assets, and obtain ratios (proportionalities) from which we can derive an "average risk price" (the cost of insuring for the risk). However, risk-pricing is intrinsically a problem-fraught process, since it relies on assumptions about unknowns, in advance of actual events, and these unknowns may include factors that were not previously anticipated or included in the mathematical models. Commenting on the information problems associated with prices, Randall S. Kroszner, a Governor of the Federal Reserve Bank
Federal Reserve Bank
The twelve Federal Reserve Banks form a major part of the Federal Reserve System, the central banking system of the United States. The twelve federal reserve banks together divide the nation into twelve Federal Reserve Districts, the twelve banking districts created by the Federal Reserve Act of...

 of the United States, theorizes:
In addition to the discrepancies between real prices and ideal prices, it may in fact be impossible at any one time to know what the "correct" price of something ought to be, even although it is being traded anyway, for an actual price. The "correct" price level is only an ideal price, namely a price at which supply and demand would tend towards balance. But because of inadequate information, that price may never be reached; supply and demand may only haphazardly adjust to each other using inadequate information. The reassurance of a self-balancing market does not matter much when people are making money, but when they do not, they become very concerned with market imbalances (mismatch of supply and demand).

When the information needed to calculate prices is inadequate for any reason, it becomes susceptible to swindles, confidence tricks and fraud
Fraud
In criminal law, a fraud is an intentional deception made for personal gain or to damage another individual; the related adjective is fraudulent. The specific legal definition varies by legal jurisdiction. Fraud is a crime, and also a civil law violation...

 which may be difficult to detect or combat, insofar as the trading parties have to make assumptions in interpreting price information where any "misunderstanding" is their own responsibility. The risks and risk-bearers may not be fully specifiable. In this context, the Stanford Encyclopedia of Philosophy
Stanford Encyclopedia of Philosophy
The Stanford Encyclopedia of Philosophy is a freely-accessible online encyclopedia of philosophy maintained by Stanford University. Each entry is written and maintained by an expert in the field, including professors from over 65 academic institutions worldwide...

 states:
This problem is compounded if various extrapolated ideal prices used to guide economic actors rely on observed trends in real prices which fluctuate a great deal in ways that are difficult to predict, and if the predictions made themselves influence price levels. It plays an important role in the theory of information asymmetry
Information asymmetry
In economics and contract theory, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other. This creates an imbalance of power in transactions which can sometimes cause the transactions to go awry, a kind of market failure...

 to which Joseph Stiglitz has made important contributions.

Price information is likely to be reliable, if market actors have a self-interest in providing true information, if it is technically possible to obtain true and accurate information, and if there are comprehensive legal sanctions (penalties) for false price information. But additionally, any market cannot function unless participants show trust and cooperation
Cooperation
Cooperation or co-operation is the process of working or acting together. In its simplest form it involves things working in harmony, side by side, while in its more complicated forms, it can involve something as complex as the inner workings of a human being or even the social patterns of a...

, and are motivated to do so.

See also

  • Price
    Price
    -Definition:In ordinary usage, price is the quantity of payment or compensation given by one party to another in return for goods or services.In modern economies, prices are generally expressed in units of some form of currency...

  • Value-form
    Value-form
    The value-form or form of value is a concept in Karl Marx’s critique of the political economy. It refers to a socially attributed characteristic of a commodity which contrasts with its tangible use-value or utility .The concept is introduced in the first chapter of Das Kapital where Marx argues...

  • Valuation
    Valuation
    -Economics:*Valuation , the determination of the economic value of an asset or liability**Real estate appraisal, sometimes called property valuation , the appraisal of land or buildings...

  • Exchange value
    Exchange value
    In political economy and especially Marxian economics, exchange value refers to one of four major attributes of a commodity, i.e., an item or service produced for, and sold on the market...

  • Character mask
    Character mask
    A character mask in the Marxian sense is a character masked or disguised with a different character. The term was used by Karl Marx in various published writings from the 1840s to the 1860s, and also by Friedrich Engels...

  • Comparative statics
    Comparative statics
    In economics, comparative statics is the comparison of two different economic outcomes, before and after a change in some underlying exogenous parameter....

  • Reproduction (economics)
    Reproduction (economics)
    In Marxian economics, economic reproduction refers to recurrent processes by which the initial conditions necessary for economic activity to occur are constantly re-created...

  • Heterodox economics
    Heterodox economics
    "Heterodox economics" refers to approaches or to schools of economic thought that are considered outside of "mainstream economics". Mainstream economists sometimes assert that it has little or no influence on the vast majority of academic economists in the English speaking world. "Mainstream...

  • Economic calculation problem
    Economic calculation problem
    The economic calculation problem is a criticism of central economic planning. It was first proposed by Ludwig von Mises in 1920 and later expounded by Friedrich Hayek. The problem referred to is that of how to distribute resources rationally in an economy...

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