To understand anything which involves humanity such as politics or sociology one needs to understand economics. This is because money is such a convenient tool it has come to represent almost everything. They say money can't buy love, it doesn't need to, people already love money, and why shouldn't they as with it you can do anything. You can buy intimate relations or just friendship, they may not be quite the same as those forged without the transfer of money but they are not as far apart as people like to make out it is. I would say that the difference between renting friends or paying for sex compared to getting them without the use of money is rather like the difference between buying some tomatoes from the supermarket or taking the trouble to grow your own. They both do the same job but the latter in both cases is more satisfying, rewarding, time consuming, subject to failure, and will taste all the better when you get it right!
With the importance of money in mind the study of economics becomes of paramount significance for any study of a subject which relates to people. A lecturer of my partner's described economics as the science of choice. Really sociology and psychology should be the macro and micro sciences behind choice, but as choice is based on incentive and money provides a universal incentive regardless of your particular tastes, then understanding economics can be a more precise way of predicting the choices people will make. I have always been a utopian, even since quite a young child yet I had little understanding nor eduction about economics until a few years ago. I quickly realised the underpinning nature of economics behind any society when I tried to first describe my utopia and so set about gaining a complete understanding of the principles and interaction of economics.
When looking to understand any system, I break the system down in to it’s component parts to analyse them. Once you have established why each aspect of the system came into being and how it reacts with the other aspects, then you are able to extrapolate a complete understanding of the whole system. Economics has been made complex by the many regulations and interactions surrounding it. All markets are controlled by numerous chaotic occurrences which makes them seem random when actually there are few relevant factors one needs to consider to understand the principles. People are more concerned with what the markets are doing than understanding why they are doing it. This is entirely reasonable as that is how one is able to make money from the markets but it does not help to improve society. The aim of this series of essays is to explain these factors in simple terms so that the fundamental principles behind economics are clear. The first essay will act as a kind of primer, the kind I should have like to have read several years ago! It will look at how and why money came into use and how a change in conditions will impact upon money and the economy. It will do little more than describe how and why things occur in a manner that I hope will not be to dull or unapproachable to the reader. Once this is done subsequent essays will build on the mechanisms described in this essay and look at the problems that are caused by the current regulations and infrastructure of the economies around the globe. I shall attempt to end the series by offering solutions to these problems.
What are the component elements of economics? Trade is the underlying concept behind economics, whether it be of goods, services, currencies or any other commodity. The earliest examples of trade may be found in social animals who trade in security, parental duties and other forms of labour. By working together they are able to achieve greater efficiencies than they would otherwise be able to if operating alone. This improved efficiency will allow the same amount of work to support a greater number of offspring which confers a greater survival chance to the continuity of the pack. The improved efficiencies can be observed in two main ways, both of which also have economic terms; the division of labour and economies of scale.
For example: A pride of lions hunts together to bring down large prey to feed the whole pride. The prey is often large and requires the team work of the pride to capture. A single kill will provide a significant quantity of food, likely far more than a single lion could make use of on their own, even if they were able to procure it that way! By working as a team, or trading labour, they are able to perform a task that provides proportionally more return on the work employed than they are able to by labouring alone. This not only shows economies of scale but also possibilities of scale. A single man may not in a single lifetime construct the Sistine Chapel as it is too great a workload.
When the lions hunt together they may well employ the fastest lion to chase down and flank the prey and the strongest lion to bring down the prey and make the kill. By doing this they increase the success rate of hunting or its efficiency and are again able to support a greater number of offspring. As the lions specialize in the various roles performed within the pride they become practised and experienced at their main roles and are able to perform them yet more proficiently. Adam Smith brought this principle to the attention of people in clearly showing how it may be used in industry to enhance productivity, however he did not invent the division of labour as that has been exploited by evolution for a much longer time.
This simple example is used in order to illustrate that trading evolved (or life evolved to trade) because it could confer an advantage. The act of trading is akin to a symbiotic relationship. Mankind evolved from a social animal and had made use of the principles of trading well before inventing the wheel or even learning to walk! We use trading in a slightly removed context from how it came in to being. A trade is usually defined as the exchange of goods or services for other goods or services. This does not make clear the case that this exchange may not be of mutual benefit. In nature parasitic relationships exist in which only one of the parties involved gains any benefit. Parasitic trades occur in human societies when errors of judgement are made or people are the victims of deceit. Worse still, trades may occur in which no parties benefit which may be due to bad judgements or just ill luck. Understandably such relationships have not evolved in nature!
Categorising trades as parasitic or symbiotic does not completely describe the state of affairs as it is an analogue scale. A trade may benefit both parties tremendously or confer minor advantage to both parties or confer a great advantage to one and a small advantage to the other. The latter example resembles a parasitic trade greater than the other examples but is still not defined as such for a single key reason. When a small advantage is to be gained it is still an improvement or an advantage. If the only alternative to the trade is to not trade is would be folly to not make the exchange. Symbiotic trading therefore increases the overall advantage of all involved in the trading. An easy way to represent this would be to say 2+2 in a symbiotic trade = >4! or in a parasitic trade may only = <4 (this same logic could also be used to define symbiotic trading as X+X = >2X). Parasitic trades may benefit a small group of people at the cost of others yet the prevalence of trade in society is due to symbiotic trades, which benefit everyone.
Before we are able to go further and show how these economic principles are manifest today in human society we must understand the concept of money and how and why it came into being. Money came into being as a tool to facilitate trade. Exchanging goods for other goods becomes difficult and laborious when multiple types of goods from various suppliers are required. This is especially the case when one only has a single commodity they produce themselves to trade for other commodities (which is incidentally the optimum condition for gaining maximum advantage from the division of labour) as it requires the people you wish to trade with to desire the commodity you produce. Convoluted trades begin to occur where intermediaries are needed to exchange your commodity for commodities desired by the people you originally wanted to trade with. By having simple and quick means of trading each exchange is more efficient leaving more time available to exploit economies of scale and the division of labour. Money does exactly that, it removes the need of any intermediary by performing the same role.
The difficulty of trade is also increased when goods are heavy, bulky, perishable or fragile, by using money in part of a trade it reduces the physical difficulties of certain goods which acts as another time saving property of money. Money also gives the ability to relate the value of a commodity to another which can otherwise be a hard task. Different commodities not only require varying amounts of labour to produce but also have a different value to different people. Barter may enable all parties to fight for the best deal for themselves but it is another activity which consumes time. Having a society-wide price for a product will normalize the price of that product and facilitate competition, a mechanism which allows trade, the division of labour and economies of scale to confer the maximum advantage to society.
The money we use today is, as an object, worthless. It cannot be consumed or worn or fulfil any other practical use. It is better understood as a representation of some labour done to the benefit of society combined with a promise from the society to repay that equivalent value to the owner. When there is no trust in the society the “value” of money falls as it ceases to command repayment and becomes akin to the useless commodity it is. At such a time the advantages of having money in a society are lost. Money came into being to allow a society to efficiently trade and easily relate value of labour and commodities. This is not the only role presently performed by money in economics due to how its use has evolved, this will be returned to later but for now all we need to appreciate are the advantages that money gives a trading society (excuse the tautology) and therefore why it came into being.
Now that we have a clearer understanding of money we can use that to show how economies of scale and the division of labour can be fully exploited in human society. Both of these principles rely on sufficient communication and cooperation to become useful. Unless you can be assured of perfect teamwork and understanding in production and trading every increase in size that is made to the trading group will reduce certain efficiencies and so the economic advantages would need to offset that to remain effective. The pack sizes of social mammals varies from species to species but nothing in the animal kingdom comes close to humanity in its ability to exploit economies of scale and the division of labour (although some insect species are very impressive). Humanity can be observed as many packs consisting of towns and cities or of nations or religions but in economic terms it is one entity and this position gives the greatest potential for creating an advantage from “nothing”. To put in more real terms, most wild animals are forced to spend a majority of their time fulfilling the basic requirements to survive and propagate while many humans enjoy a significant quantity of “free time” that they may spend at their leisure. This principle also shows how humanity has been able to increase in population as rapidly as it has done. The extra efficiencies of our production and trade allow those labours to support more and more people.
As money is, on the whole, freely interchangeable, any person who uses money is part of a giant economic whole. Currencies may be exchanged, which has ramifications of its own, but it does allow the whole globe to participate in trade. The more persons involved in trading with one another the greater the potential to exploit economies of scale and specialization. Trying to relate lions hunting to human economics is big jump and so we will use another example of a trading society. In this society we shall make a number of assumptions in order to distil the basic principles I wish to illustrate. Our society shall be of constant population size and in complete isolation, as far as this example is concerned it is the only society in existence. They use a single currency and there is a fixed quantity of that currency.
Mr A is a citizen of our example society and he supports himself by producing potatoes. The prices of the potatoes in our society are constant and depend only on the yield of the crops. A good yield may be the result of good weather conditions but it may also result from improvements made in the production methods. We shall now assume for this example that weather conditions remain constant and affect all producers equally and can therefore also be ignored. It is the nature of improvements to production and how they impact on the whole of society that I wish to focus on.
Mr A develops a new production technique which enables him to double his productivity. With no additional labour or cost used, he achieves twice the yield and may sell this at present market price for over double the profit he would have made prior to the improvements. Due to the increased production of potatoes however, there is a greater supply than the demand for them. As a result Mr A is sensible in reducing his prices to ensure that he will sell his potatoes before his competitors. This reduction in price will mean that the competitors are the ones left with the surplus supply. Mr A has greater profit margins due to his increased productivity and is better placed to win a price war as he will still be making profit at a price at which his competitors are making a loss.
Let us put some numbers into this example so that the changes may be observed.
We shall say the price of a potato in our society is 1 money.
We shall say that there are 4 producers of potatoes, Mr A, Mr B, Mr C and Mr D.
Each of these producers initially produced 10,000 potatoes annually at a cost of 1,000 money making a 9,000 money profit.
In the society there is demand for 40,000 potatoes annually at a price of 1 money each.
In the first year that Mr A produces 20,000 potatoes for only 1,000 money he stands to make 19,000 instead of 9,000 however 10,000 of the total 50,000 potatoes produced this year by Mr A, B, C and D are surplus to requirement.
Mr A reduces the price of his potatoes to 0.8 money each to ensure he sell all of his stock. This means he still makes 15,000 profit, a 66% increase on previous years despite a 20% reduction in price.
Mr B, C and D are now in a predicament as they have 30,000 potatoes to sell in a market that only requires 20,000. If they leave their prices the same and suffer the loss of sales evenly between them each only sells 6,666 of their potatoes which would make their profits on the year 5,666 money, about 63% of the previous year.
Even if they were able to retain all their customers by matching Mr A's price and sell the whole crop at 0.8 money each their profit would be reduced to 7,000 which is still only about 78% of the previous year. This is also a best case scenario for society as Mr A is able to continually reduce his prices all the way down to 0.5 money per potato without making less profit than previous years. Simply put, the society is required to pay less for potatoes as a result of the improvements to production methods as the producers reduce prices in order to retain market share.
The two previous options available to the competition show that market share is of greater importance than profit margins in terms of total profit. The best methods of retaining your share of the market is by producing quality products and charging competitive prices. It is in the best interests of the whole potato industry to reduce margins and retain market share.
Note at this stage that the only ramification to any person in this society other than Mr A, B, C and D is that potatoes are becoming cheaper to buy. Mr B, C and D are all forced into taking action as a result of Mr A's improvements. They can seek to improve their methods of production to compete with Mr A's efficiency. They could also change trades and produce a different commodity but they cannot simply do nothing unless they are able to afford a significant loss of earnings.
Let us say that Mr D decides to get out of the potato business immediately and expends his labours on producing other commodities. Mr C is frugal yet lazy and elects to do nothing as he is able to live more frugally to compensate for the reduction in profits while Mr B is industrious and sets about making improvements to his production methods. We shall say that Mr A is content with the situation also and does not wish to increase the size of his operation by purchasing the fields of Mr D. If Mr A was to use his profits to expand it would have no negative effects on the rest of society unless he obtained a monopoly on the potato market. It would be to the advantage of the society of the most efficient and cheapest potato producer was able to supply the greater portion of the market.
I have thus far described points in time and the changes that happen between them as it is the most suitable way to describe the basic principals. It is still worth pointing out that economics is, in reality, more evolutionary as it is reacting to every change to rebalance itself. In the example where the potato producers are reducing prices to retain market share it is clear that this will be a smooth and ongoing procedure and not done in steps or stages as shown.
Economics is best understood as a vast array of equilibriums. If you have a system in equilibrium governed by a set of conditions and one of those conditions is altered, when the equilibrium is re-established another condition will necessarily also have changed to balance the equilibrium. Allow me to show this in the case of the potato farmers.
Mr B is able to obtain the same efficiency in production as Mr A over a period of time however at the start of that period Mr B is still only producing 10,000 potatoes. Mr C is at that time still producing potatoes that are in demand as a total of 40,000 are produced annually (as Mr D has left the industry). As Mr B gains in efficiency over time he will begin to produce more potatoes thus creating more supply than demand.
Mr A is best suited to gaining the market share of Mr B, C and D as his production is most efficient enabling him to reduce his prices most easily. Mr B is becoming ever better at taking market share from Mr C and competing with Mr A on price. Mr C is poorly positioned to take any market share from Mr A or Mr B but initially this is not too much of a problem as Mr D has left the market leaving his previous share of the market in need of new supply.
If we assume that the initial starting condition were in a state of equilibrium (within a free market economy) in that the price of potatoes was 1 money and each farmer made 9,000 a year profit then we can make some predictions about the resultant equilibrium when production capacity has been doubled. As Mr B tends towards producing 20,000 potatoes annually for 1,000 money the price of potatoes will tend towards 0.5 money. The guaranteed competition between the three remaining producers will force prices down across the board. If both Mr A and Mr B produce 20,000 potatoes each annually and charge less than 1 money per potato and Mr C tried to keep his prices at 1 money each then all or most of the 10,000 excess supply of potatoes will be the ones produced by Mr C. Mr C will sell 0 potatoes and make a loss of 1,000 money which is not sustainable even to the frugal! This is the mechanism that ensures prices are lowered as production efficiency is increased. Increasing production at the same rate of efficiency serves no purpose unless demand for that product in society is also increasing.
The improvements made by Mr A initially caused Mr D to leave the industry. As Mr B made his improvements and Mr C remained static, he was gradually forced out of the market but his presence ensured that competition would drive prices towards the equilibrium value. This is because without Mr C their would be no surplus production and therefore no need to reduce prices to sell all the produced goods. The new equilibrium in this example is one where Mr A and Mr B both produce 20,000 potatoes annually for a cost of 1,000 money and then sell them at 0.5 money each. The cost to produce, profits, and total market quantities (supply and demand) have all remained unchanged so to redress the balance of producing twice as many the price must fall by half.
[I have assumed that reducing the price of potatoes does not increase the demand for them which based on the nature of the goods almost certainly would, even in a society with no population growth. This is because they will begin to compete for market share with things like bread and rice as they perform a similar role but the relative cost of only the potato is falling. This particular trend is not relevant in understanding the principals behind improvements and would just increase the complexity of the example.]
That example looked at a single equilibrium in isolation but I defined economics as a vast array of linked equilibrium. As a condition changes and an equilibrium linked to that condition readjusts it will have knock-on effects on other conditions that relate to other equilibriums which will in turn do the same. Some of these affected equilibrium will perpetuate the initial changes and others will retard them but in general it will ensure results that are hard to predict. What may be an equilibrium for one set of conditions may well not be for a another linked equilibrium, in such a situation there will be no smooth and gradual progression from one position to another but instead an undulation between the two systems different equilibria.
In this period of time since the first improvement the changes we have observed are that Mr C and Mr D are no longer able to support themselves in the potato industry and have been required to find work elsewhere. The profits from the potato market were also unevenly distributed between the suppliers while the improvements were at vary levels of efficiency and the supply outweighed the demand. This plight of Mr A, B, C, and D are not really the emphasis of this lengthy example but rather the effects on society as a whole.
Society has gained from the improvements made in the potato industry in that potatoes now cost 0.5 money and not 1. Each year the society when viewed as a whole saves 40,000 (total potato consumption) times 0.5 money which = 20,000 money. Let us say that within the society exists 10,000,000 money total then by saving the society 20,000 the value of money has increased by 0.2% which simply means that for the same face value of money you would be able to purchase 0.2% more of anything. This is an idealistic way to illustrate the outcome as it requires certain conditions to result in an exact, across the board 0.2% change but it does accurately show the mechanisms by which improvements benefit society.
The main assumption made in asserting that a 50% price reduction in a 40,000 money market would provide a 0.2% increase to the value of money in a society with a total of 10,000,000 money is that of perfect benefit transfer. What I mean by the term benefit transfer is the knock-on effect throughout the whole market of reducing the price of one commodity. If all people eat potatoes then it is fair to say that the cost of potatoes is involved in the cost of any task. If people need to eat to live and perform labour then by reducing the cost of eating you are reducing the cost of labour. In reality people will just have a bit more spare money which they will spend as they feel fit creating new demands. By increasing the value of money you are effectively increasing the supply of money (which is ironic as in present day economic lingo to increase the money supply is inflatory and reduces the value of money). The new demands may well find employment for Mr C and Mr D, perhaps Mr D grows sugar and Mr C makes sweets thus offering the society greater luxury consumption. In the case of Mr C and D producing sweets the market has the same nominal value of money but more goods being produced. This is another way of saying the cost of everything else must go down in order to “fit in” the extra new cost of the sweets available in the market.
An alternative solution to the equilibrium is that Mr A found it possible with his improvements to produce 10,000 potatoes for 1,000 money but in half the time. The price would remain the same as there was no influx of supply so society would not benefit in the same manner but Mr A would be working less. If you look at the society as a whole this would mean that less total labour supported exactly the same degree of “value”. This illustrates the two ways to balance the economic equilibrium when improving production methods, either less labour is required or more money becomes available to support new and different labours.
A society continually improving all its production methods is able to expend greater portion of labour on luxury and other superfluous demands or reduce its working week. Most societies have found that some combination of these two factors is how they wish to make use of increased efficiency with an emphasis of luxury consumption over reduced work, particularly in the last thirty years. As society improves its production methods gradually and across all industries the general trend in that society is lower labour time per person, greater value of money and greater quantities of available goods.
Potatoes are used in this example as they offer better benefit transfer throughout society than many kinds of production. In economics there will always be a lag phase between an improvement being made and the benefits coming to the society as a whole through the forces of competition. If an improvement was made to a very specific area of the economy, say for example a tool used in mining to extract metal ores is made significantly better. Firstly the company producing the tool will benefit, then the various mining companies will also start to gain an advantage but to a lesser degree than the tool producer. After that the companies buying the ore and using them to produce other things will notice very minor benefit and lastly this benefit will begin to minutely manifest itself throughout all of society. Some forms of improvement such as those upon crops of basic foodstuff will have a quicker, broader and more evenly distributed effect on society than specialist or luxury producers will achieve. The important point to understand is that any improvement made upon the labours of society will improve the whole of that society by virtue of the trading relationship within the society. This improvement may be measured in an otherwise constant society by the increasing value of money (or its deflation) or by the reduction of the average working week.
It must be noted here that those who instigate an improvement are only in a position to personally gain an advantage during the lag phase, or at a non-equilibrium position. Mr A in the potato example is only able to be more profitable than Mr B while Mr B is less efficient in production. When both producers are equally efficient Mr A will only be as profitable as he was before he made the initial improvements.
The way in which improvements effect society may be explained in other terms without using the altering value of money as a measure. This second explanation will describe exactly the same principle as before however in a society where many factors affect the value of money it can be useful to understand in different terms. In reality we are unable to keep influential factors constant and so our method of measure loses its usefulness. This essay is not intended to provide means of measuring the economy but to impart understanding of the important basic principals and this is why the first monetary example has been given.
To describe how society benefits from improvements to production and trade we must introduce a new concept concerning types of labour. When a cost is paid for goods or services a portion of that cost will go towards paying the labour that produced the good or performed the service. The remainder of the cost will go towards the land used to render the goods or services, the cost of maintenance and profit. These areas of cost will be returned to but for now we need only be assured that the cost paid for anything will in part pay for the labour. Even a portion of the cost of the constituent raw materials contained within any goods will be for the labour required to procure that material. Labour or work is the act of adding value to something.
The kinds of labour that exist within a society may be broken down in to two categories; those labours which support the subsistence of the society such as all the food producers, all the people who make tools which are used by the food producers, all the people involved in moving the food from where it is produced to where it may be consumed and so forth being the first category. As to what you may put in this group depends on what you define as a requirement for the subsistence of society and more importantly to what extent should those things be made available. Take the motor vehicle: humanity was able to survive for a great period of time without it. Shortly after its invention it was still only a luxury, now however many would consider motor vehicles to be essential to sustain life as we presently live it.
The second category of labour consists primarily of labours that contribute to the luxury and culture within a society such as entertainers. It is clear with this second definition that the overlap between the two categories is up to interpretation. Many other examples can be given alongside that of the motor vehicle such as healthcare, education or the computer which are not essential to sustain humanity but do facilitate it very well and would now be considered an essential. It is also worth noting that many industries overlap and perform some tasks for the “sustenance” or first category while also expending labour for the “luxury” or second category such as a logistics company who help move all manner of goods.
The important distinction between these two categories is that all of the labour found within the second category is supported by that of the first. This may be easiest to show with some numbers. If the average producer of food makes enough to support themselves and nine other people then that allows nine people for every one producing food to expend their labours on other tasks. It would be folly to produce more food than is required as it goes to waste. We can complicate our example by saying that it also requires the labours of one further person per food producer in the production of equipment for the food producer. We shall say that in this example that only food, clothing and housing are required for sustenance and that the labours of one builder or one tailor provides enough to support twenty others. In such a situation 30% of the population would be able to support the rest thus enabling their labours to go in to improving the quality of life.
For 20 people therefore 2 are needed to produce food, 2 more are needed to support the 2 food producers. 1 is needed to make clothes and 1 is needed to make houses. This means that 14 of the 20 people are able to perform other tasks.
Perhaps only 50% of the population are capable of working as the rest are children or elderly which would then mean most of the labour output by the society would be for basic sustenance.
The example with Mr A and his potatoes was used mainly to highlight how improvements to the efficiency of labour increase the value of money. It also shows that improvements that occur within the sustenance labour category will proportionally increase the number of people that it supports. The same is true for land usage in terms of how many persons a given area may support. Improvements to production methods used on that land will enable it to support more people and that will in turn free up more land for other uses or enable population growth to occur.
In this essay we have explained the beneficial mechanisms by which trade came to exist and how humanity has advanced the use of trade; with money, massive scale and extreme specialization. It was shown how improvements to efficiencies of labour come to benefit a society when competition exists, and that competition will provide an incentive to improve. Nothing I have said here is unbeknown, nor does it contain suggestion or opinion. It is hoped however, that I have managed to provide a useful basis upon which to use economics to discuss how we can make things better, and not simply more profitable. My description thus far is intended to show the important fundamental aspects of economics that relate to society rather than the individual or the business. In my next essay - “The Trouble with Money”, I will build on the ideas of this essay and show how some of our monetary systems have evolved to the disadvantage of society.
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