Economic Principles

Principles play a critical role in the development of any theory. Including economic theory.

Definition

Principle:
“A fundamental truth or proposition that serves as the foundation for a system of belief or behavior or for a chain of reasoning.” from Oxford Dictionary

Introduction

Reasoning begins with principles. We tend to ignore principles because, frequently, they seem so obvious. When we want to throw a ball over a fence, we don’t think about gravity, air pressure, friction, and other principles. But, they all affect the process of getting the ball over the fence. But, we just want to get it over the fence.

If we want to calculate exactly where the ball will land, we must define all of these principles explicitly and precisely.

The same use of principles applies to economic reasoning.

Implicit Principles

An infinite number of principles influence economic behavior. Even for sound economic reasoning, many principles can remain implicit. The existence of gravity, weather, the curvature of the earth, etc. can remain implicit unless they play an essential role in our analysis.

To think more clearly and precisely, however, we need to make some principles more explicit.

Explicit Principles

Quite a number of economic principles need explicit statement just to acknowledge their influence. Such statements avoid misunderstanding resulting from mistaken assumptions about the principles in play.

Fundamental Elements

All economic goods come from two fundamental elements: land and labor.

Land

All agricultural and “capital” goods originate with land. Agricultural goods require land on which to grow. “Capital” goods originate from elements either grown on land or excavated from land. Goods that come from water also fall within the category of land.

Labor

All goods also require labor for their production. Even the most basic goods found in nature require processing by labor. Hunters and gatherers must expend some labor to make their goods usable.

Value

Value lies at the core of many economic theories. In spite of the disagreement about the source and measure of value, all economists agree that value does exist. Because it plays such a critical role in the development of economic theories, I will discuss the theory of value in more detail in other sections of this blog.

Action

Ludwig von Mises usually gets credit for introducing the “action axiom” to economic thinking. He recognized that all economic activity begins with the action of individuals.

Mises developed this axiom using pure reason. He realized that to attempt to prove non-action a person must act—which verifies the validity of the axiom. The axiom requires no empirical testing. Its truth results from reasoning alone.

Exchange

The principle of exchange might seem obvious. It gets ignored, however, in many discussions of “buying,” “selling,” “international trade” and other market activities. These terms all represent internal references. (Left and right are internal references; north and south are external references.)

Accurate discussions of market transactions require the use of an external reference: “exchange.” A consciousness of the principle of exchange reminds people that all market transactions, as observed by third parties, involve two parties.

When discussing internal references, such as buying and selling, we must always ask about the influence and impact on the other party.

Markets

The combinations and interrelationship of exchanges created the related principle of “markets.” Most economic theory involved markets.

Money

I include money as a principle because its existence and use remains beyond a doubt. That existence provides the basis for chains of reasoning. Much reasoning regarding money remains flawed because of misunderstanding the definition of money and the source and measure of its value.

I will devote most of “Money Matters” to clearing up much of the flawed reasoning regarding money.

More…

I will discover (or reveal) more principles as I examine various topics on this blog.

Conclusion

Without principles, we cannot make theories. Without the explicit statement of important principles, precise reasoning becomes difficult.

I will expand on these principles as I continue the discussions on this blog.

Money Matters: Introduction Part 2

In addition to the topics raised in the last post, we will discuss the following topics on the way to a fuller understanding of the importance and function of money.

Monetary Systems

We will examine the essential characteristics of an unfettered monetary system. How would people use money if governments and central banks did not interfere with the system?

Banking Systems

We refer to the organizations that handle the storage and transfer of money as banks. A network of banks forms what we call the banking system.

Banking systems can facilitate the coordination of basic banking functions. But, they can also manipulate the underlying monetary system.

Subsistence Fund

When we use money in market transactions, the money simply facilitates goods for goods transfers. Those transfers involved a vast number of goods, and each transaction has a different characteristic.

To make general statements about money I will describe a mental model frequently referred to as a “Subsistence Fund.”

Without further description, the subsistence fund consists of a collection of consumer goods required for the population of an economic system to subsist. I will flesh out this description later on this blog.

Pricing Mechanisms

Pricing mechanisms — particularly those based on money — perform a critical function in the transfer of market information.

We will examine market pricing and how flexible prices facilitate dynamic markets.

Intervention

Unfortunately, government and the banking system intervene in the smooth flow of money. This intervention disrupts the pricing mechanism creating a massive amount of misinformation within otherwise effective and efficient markets.

Money Myths

During the course of this blog, we will address many of the misconceptions about money and the banking system. We will address some of the more egregious myths and misstatements about money and banking.

Conclusion

Many people seem to disconnect money from goods or products. They either mention money and say very little about products exchanged, or they mention products and basically ignore the existence of money. Every mention of economic transactions should include the interrelationship between products and money.

The lack of systemic thinking provides one reason why people talk about one side of these exchanges and not the other.

Ignorance and misunderstanding provide another reason for people to ignore the connection between goods-for-goods exchanges and the role of money.

Money Matters will address these connections and correct much of the ignorance and misunderstanding about money and markets.

The next time you go to a store, a coffee shop, or a restaurant, think about the critical role that money plays in your everyday life. Don’t you think you should understand it?

 

Money Matters: Introduction

The ubiquity of money in market transactions means that a precise understanding of market activity requires a precise understanding of money. Money Matters will expand the understanding of money and reduce much misunderstanding.

The Donkey

A rich man stopped in a small town. He encountered two men haggling over a mule. The rich man, thinking he could use the mule, out bid the two men and bought the mule.

Several weeks later the rich man again stopped in that small town. By coincidence, he encountered the same two men who had been haggling over the mule. The two men asked the rich man what he had done with the mule.

He responded, “That old mule could not do the work for which I wanted him; so, I had him put down.”

The other two men suddenly look very disappointed. The rich man asked them why they acted so disappointed.

The men responded, nearly in a single voice, “Until you came along, we had made a good living trading that mule.”

Market References

Fast food, shoes, iPads, Ferraris, Stocks & Bonds, and the national economy, we relate to all of them through references to money. We use phrases like: it costs…, it’s worth…, it increased by…, all followed by a number of dollars. We use these phrases as if they actually mean something and that we understand that meaning.

But, do these phrases mean anything?

Do we know whether we speak real meaning? If they do speak meaning, do they comprehend that meaning?

The Comprehension Gap

When we discuss market transactions, we tend to either ignore the role of money in those transactions, or we discuss monetary transactions, with little attention to the goods at the focus of the exchange. By ignoring the interrelationship between money and products we tend to expose what I have dubbed a “Comprehension Gap.”

What don’t we understand? Money or markets?

The donkey trade and the economic references provide hypothetical examples of this “Comprehension Gap.”

Money & Markets

You cannot fully understand most economic exchanges without understanding money and its role in exchanges. If we base our understanding of free markets on our current assumptions about money, we could suffer from grave misunderstanding. We need to make those assumptions explicit and precise to assure that our assumptions correlate with the real nature of the transactions.

So many misconceptions exist about money that clear thinking and communication about economics becomes nearly impossible. To clear up this confusion, we must start with some basic concepts

Economic Reasoning

Money exists inside and as part or market systems, not as separate from market activity. Thus, in order to fully understand money (and close the comprehension gap), we must first understand the principles and theories that govern market behavior.

I will address some of the basic elements of economic reasoning that will support our discussion about money.

Market Systems

Expanding production and limited consumption result in savings, and creates the need for exchange and the use of money.

How does the production process create a need for exchange?

How does increased production and exchange benefit all members of an economic system?

Exchange

Nearly all market exchanges involve money. In large markets, systems of exchange become highly complex.

How does that complexity lead to the use of money?

To understand to role of money in complex market exchanges we should know the basics of market exchanges.

We will examine market exchanges at all levels of complexity — from the simplest, which might operate based on direct exchange, to the complex, which require indirect exchange and the use of money.

To be continued…

Money Matters – Preface

With this post, I begin blogging a book I will entitle Money Matters. When I finish, I hope that both you and I have a better understanding of money and free markets.

Economic systems operate in the context of markets. Without the exchange of goods and services that create markets, no economic system would exist. Learning about economic systems, or markets, should help us to operate more effectively within them. We don’t want to learn about markets in order to change the rules by which they function. Those” rules” have manifested from the interactions of millions of people over thousands of years. We cannot outsmart the distributed intelligence of all those individuals. We can, however, play the “game” and operate in the market more effectively, if we know the rules.

If you want to become proficient at chess, you first learn the rules of play. You then develop strategies, within those rules, for “winning” the game. The same holds true of the “game” of markets.

Most exchanges involve the use of money. Understanding markets, therefore, requires understanding the meaning of “money,” its role in markets, its source of value, its measure of value, and the operation of the banking system that handles money transactions.

In other words, Money Matters.

But, most people do not understand the most important aspects of money. You might say they are like the novice chess player who doesn’t know how to distinguish the chess pieces. Reading the rules does no good for developing a strategy. In his ignorance about a fundamental element of the game he misinterprets the rules of the game, or, worse yet, he starts making up his own rules.

If I have not stretched the chess analogy too far, I mean to convey the idea that people don’t understand markets when they don’t understand money. Because of this lack of understanding, they misinterpret the “rules” of markets. Based on their misunderstanding of markets they attempt to write new rules. Changing the rules does not improve the game. It changes it.

Free markets, unlike chess, do not have winners and losers. All free market players win.

It concerns me that, because people do not understand money, they don’t understand markets. As a result, they operate in markets by unrealistic rules that create winners and losers, instead of just winners. -For that reason, I have decided to blog a book that I will title Money Matters.

I base this book on the premise that: you cannot understand modern markets if you don’t understand money. The real focus of this book will be markets, not money. I will clear away many misunderstands about markets by refuting some of the false assumptions that people have about money and the banking system. Since money exists as an integral part of the market system, I will explain money in terms of market principles and theories. In the end, I want readers, and me, to understand markets and money in a way in which we can make them understandable to friends and acquaintances.

This book represents a work in progress. I strive for clarity and accuracy. If you have the basics of an idea, you will have the tools with which to learn the details.

Please help me, with comments and questions, to improve this book as I move along. I will respond to all comment by either:

  • editing existing posts, or writing new ones, if the comments are general, or
  • responding in the comments, if the comments are specific for you.

I will also post this preface on the About Money Matters page.

 

A Pricing Model

No one can build a model to either determine or predict prices, despite the useful information that prices provide. Attempts to predict prices will always prove fruitless.

Knowing prices in advance would prove useful to owners and managers in all businesses. Imagine the profitability a company that could accurately predict the future prices of its products. I will show that the best that we can do is interpret price patterns in order to make subjective judgments about market opportunities.

I will step through three different levels of models and explain their relative usefulness:[1]

  • Events
  • Patterns of Behavior
  • Market Structure

Events

Models to Determine Prices

Despite what they teach in basic economic classes a person cannot predict individual prices by finding the intersection of supply and demand curves. If you think about this for about 12 seconds, you will realize that no one has ever seen a supply or a demand curve. Economists draw these curves, after the fact, in an attempt to explain the behavior of buyers and sellers.

The fact remains that buyers act based on their scale of preferences and sellers must make reasoned guesses about what buyers might pay for their products. Business schools teach managers to make sophisticated models to develop offering prices based on their cost structure. That exercise, however, provides no guarantee that buyers will pay that price.

Patterns of Behavior

Models to Interpret Prices

Over a period of time patterns develop that indicate the prices upon which buyers and sellers agree. These patterns do not provide any prediction, but, based on the assumption that the past is an indication of the future, these patterns do provide some useful information.

Rising Prices

A pattern of rising prices provides significant useful information for entrepreneurs. A pattern of rising prices indicates relative shortages in a particular market and the possibility for profitable opportunity. If buyers willingly pay more and more for a good, it indicates that they have relative difficulty in finding that good. Entrepreneurs can exploit that opportunity. (See diagram below.)

Rising Prices

Declining Prices

Declining prices, on the other hand, indicate relative excesses in a specific market. Depending on the steepness of the decline entrepreneurs might decide to reallocate their capital to more profitable opportunities. (See diagram below.)

Declining Prices

Market Structure

Pricing Causal Loops

An accurate model of the market structure would provide the most accurate prediction of market prices. In the diagram below, I have sketched a conceptual model of a simple market structure. Briefly it would operate in the following sequence:

  1. Increases in production lead to increased inventory.
  2. Increased inventory leads to a reduction in production. These two steps create a balancing process. Additional reinforcing processes influence these two steps.
  3. Increased efficiency leads to reduced prices and increased production.
  4. Reduced prices lead to increased sales
  5. Increased sales reduce inventory leading to increased production.

If a modeler knew all these variables, he could accurately predict the behavior of the system.

Causal Loop

This model, however, has one fatal flaw. It represents a human system in which people act based on subjective judgments. As described in the section above no one can predict individual prices. We don’t know until after the fact what buyers will voluntarily pay for the goods in question.

When attempting to build models of markets, modelers make the mistake of assuming the patterns of behavior represent the mental models of buyers. (I.e. they confuse the map for the territory.) Prior to 2008 house prices rose consistently year after year for several decades. Market watchers mistakenly assumed that that trend would go on “forever.”

The preferences of individuals can shift suddenly, changing the structure of the market, creating entirely new patterns of behavior. No one can predict when these shifts in preferences will occur. No one can know when prices will change.

Conclusion

No reliable model for pricing can exist. Patterns of behavior provide the most useful models for interpreting market behavior. Rising prices generally signal shortages. Falling prices generally signal abundance. But, market participants must view these patterns with great caution.

In a free-market, buyers can shift their preferences relatively swiftly. But, in markets subject to intervention outside forces work to distort those preference scales, causing price distortions, misinformation, and the misallocation of resources.

  1. I base my statements on an assumption of no intervention in the market. I assume, for the sake of discussion, that fiscal redistribution, regulation, and monetary policy have no influence on market pricing. 

Value Measure-Review

Because I will frequently return to the subject of value, and its measure, over the course of these blog posts I have decided to publish the text of the same article I posted May 16, 2016 (with some edits).

If individuals provide the only sources of value, how do those individuals measure value? Does every person have a standard unit of value to compare the economic value of one good to another?

In fact, value has no unit of measure. Unlike height, weight, volume, etc., people have no way to compare their values with those of other people — or, indeed, with the goods they value themselves. Value has no objective source; and value has no objective measure. Only the subjective preference scales of individuals provide a measure of economic value. An individual can only value one economic good more or less than another economic good. A person cannot quantify how much more, or less, he or she the values that good.

Example

Preferences
Hypothetical Preferences

A hypothetical example (see right) might prove useful. This list shows the preferences (listing the most preferred at the top) of one individual for some fruits in a selection at a specific time and place.

The order of these preferences might change in a different time or place. Also, this person cannot tell how much they prefer the peach to the pear.

Important Factors

I will touch briefly on several important factors about preference scales—like this example.

First, preference scales only exist in an instant. A person can prefer ice cream to cantaloupe in one moment and cantaloupe to ice cream in the next.

Second, the unit of measure (e.g. quantity, volume, length) of a good affects its place on the preference scale. A person might place a bowl of ice cream high and their preference scale but a gallon of ice cream relatively low.

Third, distance affects preferences. Goods nearby have more value than goods in the distance.

Fourth, time likewise affects preferences. A good in the present has more value than the same good in the future.

Fifth, each additional unit has less value than the previous unit — all at the same time and place in the same units. The second bowl of ice cream has less value than the first. The 100th bowl of ice cream has less value than the 99th, the second, and the first. Not after eaten, but in the moment when the individual decides to buy them.

Sixth, context — weather, hunger, social situations, etc. — has an effect on relative value. A cold man might place more value on an ugly coat than a warm man, who might prefer a more fashionable coat.

Other factors can affect value scales, but these are some important ones.

Summary

  • Individual preference scales provide the only measure of value.
  • Those preference scales have no units of measure; only ordinal ranking.
  • Preferences exist only at a point in time.
  • Many factors affect preference scales including space, time, units, and context.

In the next post I will address the relationship between value and price.

Value Source – Review

On May 11, 2016 I posted an article describing the source of economic value. I revisit that subject because of its vital importance to economic reasoning.

In this post I will respond to some questions which have arisen since I posted that article more than two years ago. I’m sure that these questions are not all-inclusive. Thus, I will address the source of value when it becomes pertinent to other topics on this blog.

Validation of Source

How do we know that individuals are the only source of value?

Of all the sources that have been proposed for economic value, only the individual as the sole source holds up to logical scrutiny. Every other source, whether it be intrinsic value, labor input, or production cost, require some modification when looked at in detail. The only element consistently involved in the determination of value consists of individual people.

Economic goods seem to have different values under different circumstances and different uses. This fact negates the validity of any intrinsic value.

The production of nearly identical economic goods can require vastly different degrees of labor in terms of time and quality. Thus, no consistency exists in the labor theory of value.

Different producers of nearly identical economic goods can have significantly different cost structures. The cost of production theory of value also fails logical tests.

On the other hand, the existence of value always involves individuals.

Use or Exchange

Is there a difference between use value and exchange value?

Some theorists have attempted to distinguish between “use value” and “exchange value.” From the standpoint of source these distinctions make no difference. From the standpoint of the individual “exchange” consists of just another form of use. This provides yet another consistency in advocating that individuals provide the only source of economic value.

Value of Money

Does money have a different source of value than other economic goods?

Some people have the mistaken impression that money has a different source of value than other economic goods. This could not be further from the truth, for money consists of just another economic good (or the claim for an economic good.) The only significant difference on this good is that it’s held for the purpose of indirect exchange. It has, however, exactly the same source of value as does any other economic good.

Conclusion

Having a logically consistent source of economic value plays a critically important role in the development of logically consistent economic theory.

The development of reliable theories in any field of study relies on consistent fundamental premises. The same applies to the source of value in the development of any reliable economic theory. The only consistently fundamental premise in the development of theories of value consists of individuals as the source of value.

I shall return to the importance of this fact many times in the course of my blog entries.

Introduction to Exchange

Exchange, a simple concept on the surface, has broad and profound implications in economic theory. All economic activity—all market activity—consists of exchanges. People, individually, exchange one condition for another—sleep for wakefulness, food for hunger, uncleanliness for cleanliness, and more. Cooperatively people exchange services for goods, goods for services, services for services, and goods for goods, and these exchanges form a network of interactions we refer to as a market.

Exchanges provide us with the objective information we need to make affirmative statements about market activity and what drives it. We can say what goods actors prefer over other goods. We can identify the breakdown of the division of labor. We get an understanding of comparative advantage. And more….

In spite of the objective information derived from exchanges, we must take care to not misinterpret that information. Prices, for example, provide significant data, but they do not give us a precise measure—or indicator—of value. We can only say definitely that the parties to the exchange valued what they received more than what they gave. So, a price—whether in terms of a money commodity or goods—does not give us a “market value,” as so many would say. Prices only provide an indication of actors’ preferences at a particular point in time. We can only assume that those preferences will not change significantly in the short-term. I should repeat: a price does not measure value.

I also need to make a clear distinction between “buying and selling” and “exchange.” “Buying and selling” make internal references. Whether a person buys or sells depends on their Individual perspective. “Exchange” makes an external reference. It does not matter whether one adopts the perspective of one actor, another, or an outside observer. These relationships are analogous to “left and right” and “north and south.” North and south remain the same regardless of perspective. Left and right, however, depend on the direction a person faces.

I have made the above comments as an introduction to exchange and its importance. I will break down the types of exchange in the next post or two.

Subjective Value

I have described, in earlier posts, some of the underlying concepts of the “Subjective Theory of Value.” In summary, individuals determine economic value subjectively and individuals establish their own measures of value based on subjective scales of preference. Individuals reveal their preferences, without precise units of measure, when they make an exchange.

These simple principles provide the basis for a complex system of values and action which create a network of relationships we refer to as a market. I will describe many of these complexities, and how they relate to market activities in future posts, but, for now, I want to sketch out an hypothetical situation that I hope will help you relate to the role of subjective value in your own actions.
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John wanders the streets of the art village in search of a picture to decorate his living room wall. He encounters a store called “The Same Price Art Store”. The sign in the window says, “All art the same price,” and it quotes a price well within his budget. He steps inside.

As he enters the store he is immediately impressed by the quality and selection of the art on display. Almost instantly, however, he notices some of the works that will not fit the decor of his home. He quickly sorts through the remaining selection and purchases an attractive landscape photograph.

So, what does this shopping experience have to do with economics, free markets, and value?

Shopping for artwork provides a good example of the real source and measure of value—and hopefully one to which you can relate.

First, John subjectively places relative values on all the art and ranks a particular piece of art above the rest. He has no other source for that value other than himself—whatever scale he places on that value.

Second, he has created a unique measure of value. He has a preference for a particular piece of art over all the others available at The Same Price Art Store. Since all pieces have the same monetary price, in this scenario, money price plays no role in the choice of art. (I will explain the role of money in future posts.)

Fourth, by acting on his preference, he has created objective evidence of his preference. For the first time during his shopping trip observers can see, by John’s actions, that he prefers that particular piece of art more than the other works in the shop and more than whatever money he given for the art.

This hypothetical example demonstrates how value originates with an individual and how the level of that value derives entirely from the ordinal preference scale of the individual.

Now, create your own example. See how, for you, every determination of value results from your own subjective judgment, and that you measure that value only in terms of your preference over alternatives available. Regardless of what sort of purchase or exchange you make—for fruit, smart phones, cars, clothes, or art—you alone determine what you value and how much.

Subjective value and ordinal preferences make quantitative economists rather uncomfortable. I will demonstrate in this journal that Subjective Value Theory provides the only logically consistent explanation for the establishment of economic value, which provides a basis for understanding all economic activity.

Value: Exchange

In the previous two posts I have explained that the judgments of individuals provide the only source of economic value, and the ordinal preferences of individuals provide the only measure of economic value. So, how can these individual subjective values provide any useful information to those actors and for any outside observer?

The subjective values of individuals become useful to the market when an exchange occurs. Let me demonstrate with a very simple hypothetical example.

Two individuals, John and Charles, have a chance encounter. John happens to have with him an item that I will refer to as “A.” Charles has with him and item that I will refer to as “B.” We cannot hear their conversation but we noticed that when they part John and Charles have exchanged these items. Now Charles has A; and John has B. This exchange gives us as observers — and also John and Charles as participants — some information about how they respectively value these items.

Although prior to this exchange we knew nothing about the preferences of either John or Charles, we can now say with absolute certainty that John prefers B more than A, and Charles prefers A more than B. In general, when an exchange occurs we can always say that each party to the exchange gets what they value more than what they give. We have no way of measuring how much more they value what they get, but we can say with certainty that they do you value it more.

We have confidence in what we know about these relative values simply because the exchange occurred. If John and Charles did not value what they got more than what they gave up, the exchange simply would not have occurred. To add a little clarity let’s look at three other possibilities in which an exchange would not have occurred.

  • John values A more than B and Charles values B more than A. In this case they both consider themselves better off with what they already have.
  • John and Charles both value A more than B. In this case, although Charles would like to make an exchange, John has no desire to do so.
  • John and Charles both value B more than A. In this case, although John would like to make an exchange, Charles has no desire to do so.

The following graphic shows the alternatives possible when John and Charles meet. Notice that, in these possble scenarios, no exchange occurs when either party prefers what they already have—no matter what the other party prefers.

Preference Table
Preference Table

When John and Charles happened to encounter each other they experienced what economists refer to as a double coincidence of wants: each of them wanted what the other had more than what they possessed. In a worldwide economy consisting of billions of participants and billions of products the double coincidence of wants occurs fairly rarely. I will discuss the more complex nature of market exchanges in future posts. This hypothetical example, however, provides a simple demonstration of how the subjective preference scales of individuals become exposed by their actions.

I do want to point out the most important common element in the sources and measure of value and the market exchange: the individual. The values and actions of individuals represent the core of all economic activity.


In my next post I will provide a summary of the source and measure of value, and how exchange reveals value.: Summary of Economic Value