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April 12, 2011

Economics at AoSHQ U: Part 1 - The Economy

(This is the first in a series of posts about the basics of economics. Feedback and corrections cheerfully ignored accepted. If you have specific questions and/or requests for clarifications, post them in the comments.)

DISCLAIMER: I am not a Nobel Prize-winning economist who works at the New York Times. I don't even play that guy on TV. If you prefer your Economics backgrounders from actual smart people with degrees, Thomas Sowell is your go-to guy.

What is an “economy”?

It is a state of Nature that exists when scarce goods that have alternate uses are allocated in a competitive environment. Note the “state of nature” part of the description. An “economy” is not a human-devised system imposed on Nature; it is a state of Nature imposed on humans (and everything else that crawls, walks, swims, or flies). It is scarcity that drives the supply/demand dynamic, with competition among both producers and consumers being the defining characteristic. “Economy” is simply a descriptive term for how the supply/demand dynamic plays out.

Human beings, to survive, need things that are inherently scarce -- food, shelter, clothing. In our hunter-gatherer days, we spent much of our lives trying to meet our most basic needs. If we needed food, we had to hunt or forage for it; we got our clothing from the animals we killed or from our foraging activities; our shelter was whatever we could find in our environment. The demand for the necessities of life was very high, but the supply was comparatively low -- hence the “price” of these things was enormous, in terms of time and energy required to acquire them. The cost was so high, in fact, that it left us with little time to do anything else. We spent most of our time and energy just trying not to die.

The advent of agriculture and animal husbandry brought the need for a more efficient way to allocate scarce resources, and a need for specialization of labor within the economy. This led to the next stage in economic development: barter.

In a barter economy, a person can trade one good directly for another. If one needs grain and has a spare deerskin, one can trade the deerskin for grain...assuming one can find a grain-having-deerskin-wanting trade partner. If the grain-haver wants (say) a bow or pair of sandals or a clay jug instead, an intermediary has to be found who has that item in order to get the grain. Barter allows a specialization of labor: farmer, blacksmith, shepherd, weapon smith, soldier. A person can apply his skills and talents to a few specialized tasks, and trade the products of his labor for things he cannot make or procure on his own. But due to the inefficiency of the barter system, specialization of labor cannot proceed too far because subsistence must still be paramount.

For all the benefit it brings over a bare subsistence hunter-gatherer economy, a barter economy is inefficient and has hard limits as to how much it can grow. It is wasteful of time, goods, and labor. So it is no surprise that barter economies tend to grow into...market-based economies based around a generalized unit of exchange (“money”). (NB: “Money” wil be discussed in a future post.) A generalized unit of exchange allows an economy to grow for many reasons: it allows a more efficient use of scarce resources; it allows increased specialization of effort by laborers; and it facilitates new concepts like employment (for wages), investment and saving.

The mechanism by which scarce resources are allocated is pricing. Prices are not set arbitrarily. Prices come about through a complex series of interactions between buyers and sellers of scarce resources that have alternate uses. If supply is low but demand is high, prices rise; if supply is high but demand is low, prices fall. Pricing is not absolute -- it is a continually-fluctuating relationship between supply and demand, buyers and sellers. The price of a good is only loosely connected to its inputs (the raw materials, time, and labor required to bring it about) and is mostly a function of demand in the marketplace.

Everything in an economy has a “price” attached to it (or a “cost”, if you are a buyer). Time, labor, transport, preparation...all must be factored into the equation for the price of a good. “Services”, in fact, arise as a second-order effect of allocating scarce goods with alternate uses, and services themselves must be priced according to the laws of supply and demand. Even an individual in the workforce is priced in this fashion: the wage a worker is paid is his "price" on the market.

For example, a brick-maker is not just selling you bricks; he is selling you his expertise and time. The brick-maker must price his time and talent in such a way as to make it profitable to make bricks rather than, say, pots or water-jugs. He must compete with other brick-makers in the marketplace, and consumers see the effects of this competition in pricing: he may lower his prices to match his competitors, or leave his prices higher but provide a better-quality product. If the brick-maker fails to align his price to the prevailing market consensus, he will go out of business. This is the process that drives innovation and technological change: if the brick-maker can find a way to make twice as many bricks as his nearest competitor, or find a way to make his bricks of far higher quality for the same price, he will prosper greatly -- until his innovation is copied or stolen by his competitors and the price-competition starts anew.

Another thing about prices: they are relative to the unit of exchange. You can say that an brick “costs” $1, but you can just as well say that a brick “costs” 1/10th of a shirt, or twenty-five raisins, or ⅓ of a measure of grain, or five minutes worth of yodeling (for a brick-having-yodeling-wanter, anyway). Having a generalized unit of exchange makes price-calculation more efficient, but it’s important not to lose sight of the fact that a good or service’s “worth” or “value” is still relative to other goods and services, not to the unit of exchange itself.

So much for “prices”. What about “profit” and “loss”? These terms are harder to quantify because in a market economy, “profit” depends on the personal calculus of the seller of a good or service. A seller knows his inputs: materials and facilities (capital), time, expertise. He knows the prevailing price for the good or service he proposes to provide (or if he’s an innovator he makes an educated guess). He has to derive a price based on this calculation that allows him not only to recoup his costs, but to have some exchange-units left over with which to buy other things for himself that he needs (food, clothes, etc.). This is called his “profit”. (He may find that he cannot charge enough to recoup his basic expenses; he’s spending more than he can sell the good for. This is called a “loss”.)

Take our brick-maker again: if he works in a highly-competitive environment, his profit-margin may be very low; if he’s the only brick-maker for miles around, he can make a tidy profit on his labors. If his profit is too low, he may go out of business; if he charges too much, he promotes competition from other brick-makers who will undercut his prices.

The constant push-pull between sellers who wish to maximize profit and the buyer who wishes to get the lowest price ends up providing a very efficient mechanism for allocating scarce goods.

An “economy” is simple in theory but complex in execution because the individual interactions of millions of participants working for their own self-interest presents a mind-boggling array of possibilities. But at base, you’re still talking about allocating scarce goods with alternate uses, and the services that spring up as a second-order effect of that process.

Markets are largely self-organizing (Adam Smith’s “invisible hand”), though humans persist in trying to tame them via regulation and governmental controls -- and usually to detrimental effect. The more control a government tries to exert over the market, the faster the economy fails. No person or group of people is smart enough to make the innumerable small decisions that make a market economy function; it’s impossible to see the entire picture, or know how all the various pieces fit together. Freer markets are more efficient markets, and freer markets tend to have the best outcomes for the people who participate in them.

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posted by Monty at 09:53 AM

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