Economics For Beginners: How The Economy Works
In my last article (8 Truths About The Economy That Everyone Should Know) I talked about how no one can actually “fix” the Economy, because the Economy isn’t a “thing”, it’s made up of people. That lead to this question by one of my favorite fellow Hubbers, savvydating (seriously, if you’re not following her, you should be):
“…at what point does an organic economy need to be interfered with and how--generally speaking”
That’s a great question, and one that certainly deserves more than a quick blurb in the comment section of one of my articles. I’m certainly going to cover that in a future article, but it also made me realize that to really answer that question, I first needed to explain how the Economy actually works. So that’s what I’m going to do today in this article.
Fair warning, this is going to be a long one, but it’s also going to serve as the point of reference for the entire Economics For Beginners series.
What The Economy Is And How It Works
At its core, behind all of the charts and graphs, and under all of the overly complicated terminology, the Economy is nothing more than a blanket term for the things that people trade with each other; that’s all it’s ever been. If you go back to the very first humans, the first time one of them decided to keep a few extra sharp rocks on hand, or to save some food for later, that was the very first Economy.
And so, over the years as human became more advanced and we started making and trading more and more things, the Economy got larger and more complex. Let’s take a look at a couple of those cavemen; we’ll call them Bob and Tom:
One day, Bob and Tom go out and kill a Woolly Mammoth. They decide to divide things equally among them, and so they each bring home: 200 pieces of meat, 1 of the tusks, and they cut the pelt into 2 smaller pieces and each takes one. So, that Economy is made up of 400 pieces of meat, 2 tusks, and 2 pieces of Mammoth pelt.
The Economy: The Economy is the all of the things that people have to trade with each other. This can include products and services.
Economics: Economics is the study of how people trade the things they have, for the things they need and want.
Market: A Market is where people come together and trade goods and services. A market can be as small as two people, or as big as an entire country. For some goods and services, the market is the entire planet Earth.
So now Bob and Tom have their meat, their tusk, and their Mammoth pelt, and all is right with the world. Every few days, Bob and Tom repeat this process: they go kill a Mammoth and divide it up equally among them.
One day, they find a couple of cave women, we’ll call them Mary and Jane. Mary and Jane have a new invention called the Bow. The Bow uses sharp little sticks called Arrows to kill Mammoths from a distance. This invention makes Mammoth hunting much safer, since they can be used from a distance. There is much less effort involved, which will allow Bob and Tom to kill twice as many Mammoths each hunting trip.
Now while Mary and Jane are brilliant weapons designers, they aren’t very good hunters, so they’ve been living on plants and berries. They’ve also been making clothes by weaving grass and leaves into material, but they’d much rather have nice warm Mammoth pelts to make their clothes with. Something big is about to happen.
Bob really wants a Bow. He knows that it would make hunting Mammoths so much easier, not to mention safer. So Bob looks at what he has: meat, tusks, and Mammoth pelts, and decided to see if he can trade some of that for what he wants: a Bow. In that one instant, Economics is born.
The next day, Bob and Mary have both had the same idea: Bob wants Tom to help him take some of their meat and animal pelts over to Mary and Jane, and Mary wants Jane to help her take a couple bows to Bob and Tom. Bob and Tom decided to take 100 pieces of meat, 10 tusks, and 10 Mammoth pelts to trade with Mary and Jane, and Mary and Jane decide to take 2 Bows, and 100 Arrows to trade with Bob and Tom.
By taking some of the things they have, and trying to trade them for things that other people have, Bob, Tom, Mary and Jane have created the very first Market.
Money: Money is a medium of exchange that is used to trade for goods and services.
Price: Price is the amount of money that you must trade for a particular good or service. Prices are set by the person selling the good or service and are generally static, meaning that they are the same for everyone (a gallon of milk is the same price for all shoppers).
Value: Value is the importance or usefulness you place on an item. The more important or useful something is to you, the more value it has. Because not everyone places the same value on everything, value is subjective.
Money, Value, and Price
So now we know what the Economy is, and we have a basic grasp of how it works: as you just learned, the Economy is made up of the things that people have to trade with each other. Now let’s look at our previous example:
What if Mary and Jane didn’t want any of the things that Bob and Tom had? Bob and Tom would still want a Bow, but since they wouldn’t have anything that Mary and Jane wanted, there would be no way for them to get one. Enter the wisest caveman of all, Joe.
Joe has a bunch of clamshells. The clamshells are great for making arrows, tools, necklaces, and all kinds of great things that everyone likes. So Joe has an idea: since everyone likes clamshells, Bob and Tom can trade their goods for clamshells, and then use those clamshells to trade for a Bow from Mary and Jane. Joe just created the world’s first form of Money.
So now Bob and Tom take their clamshells to Mary and Jane and exchange for a Bow. It’s a win-win situation: Bob and Tom got something they wanted, and Mary and Jane got something they wanted.
This is how the Economy still works to this day: people all over the world use money to trade for goods and services. But who sets Prices, who decides how much money should be traded for things; in short: who decides how much things cost? Believe it or not… you do.
Every time you buy something, what you’re doing is saying that you value the thing you want, more than the thing you have; that your value of the item is greater than its price. This is true for every purchase you make, no matter how big or small. For instance, when you go to the store and buy a gallon of milk, you’re saying that you value that gallon of milk more than you value the money you’ll have to trade for it. This is where Value comes into the equation.
How do you determine the value of a gallon of milk? You take the price, and weigh it against the value of the benefits you receive. If that gallon of milk costs $3, when you go shopping you’re essentially asking yourself: is having milk in the house worth $3 to me? If the answer is yes, then you buy it, if it’s no, then you don’t.
Demand: Demand is the amount of an item that customers are willing to buy at a specific price.
Now what happens when one of the variables in this equation changes? What if that gallon of milk cost $30? Now you’re asking yourself: is having milk in the house worth $30? Chances are not many people are going to be willing to pay $30 for a gallon of milk, meaning that they value $30 more than they value the benefits of having milk. Unless something happens in the future to increase the value they place on the benefits of milk, it’s unlikely that they’ll buy it at that price.
Now what if something does happen to change how you value the benefits of that gallon of milk? Say you really miss having milk in your coffee/cereal, each morning. Well, as the value you place on the benefits of milk increases, so too does the price you’re willing to pay. This is known as Demand, and it’s super important.
Since more people were willing to buy milk for $3 a gallon, the Demand was much higher than it was when the price of milk rose to $30 a gallon. This means that: when the price of an item goes up, Demand goes down; likewise, when price goes down, Demand goes up.
Now it’s also important to note that Demand has an evil twin out there: Consumption. We’re not going to talk about him right now, but you need to keep in mind that there is a big difference between Demand and Consumption.
"Demand" In Action During Holiday Shopping
Supply: Supply is the amount of an item that someone is willing to sell at a given price. The more of a thing there is, the lower the price will be; the less there is, the higher the price.
Surplus: A Surplus is created When Supply exceeds Demand. Prices fall since there is more of a certain thing than there are people willing to buy it.
Shortage: A Shortage is created when Demand exceeds Supply. Prices rise since there are more buyers of a certain thing than there are units available for purchase.
Demand determines how much of a thing people are willing to buy at a given price, but what sets that price in the first place? The answer: Supply.
Since we learned that price and Demand are linked, how then does Supply interact with Demand? Let’s check in on our cavemen and see how their society is going:
The last time we checked, Joe had just used clamshells to create the first money, which Bob and Tom each then used to buy a Bow & Arrows from Mary and Jane. Using a Bow and Arrow made hunting Mammoths easy, and Bob and Tom were able to earn a lot of clamshells by exchanging the resources they collected to Joe.
Things were going great, so great in fact that soon cavemen from all over the area started moving into the neighborhood. Some of them were hunters like Bob and Tom, and some of them made Bows and Arrows like Mary and Jane.
Not long after, Bob and Tom went to see Joe to trade more of the resources they had collected for clamshells. When they got there, there was a long line of cavemen waiting to see Joe. When they finally got to Joe, he told them that he wouldn’t be able to give them as many clamshells as he usually did.
He explained to them that, since there were so many people now hunting Mammoths, there was so much more meat available that meat was no longer as valuable as it was when it was just Bob and Tom bringing in meat. So Joe gave Bob and Tom half as many clamshells as he normally did.
You see, as the Supply of meat increased in our caveman community, Joe’s Demand (the amount of meat that Joe was willing to trade for at a specific price) went down. Meat was now plentiful, and readily available, so the value he placed on meat was no longer equal to the value of the clamshells that people were asking for in exchange.
The same thing was happening to Mary and Jane, since there were so many more people making Bows & Arrows they had become much less valuable. As such, fewer people were willing to give Mary and Jane as many clamshells as they used to for a Bow. Because Supply exceeded Demand, Mary and Jane were forced to accept fewer clamshells for each Bow they sold. This creates a surplus of Bows and Arrows in the market.
Supply & Demand
Bank: A Bank is an institution that accepts deposits from customers.
Debt: Debt is the state of one party owing something (in this case money) to someone else.
Currency: Currency is a medium of exchange that is nearly identical to money, except for the fact that money has a store of value. 99.99% of the time these two terms are used interchangeably, but there is a difference.
Interest: Interest is the price one pays for borrowing money. Interest can be a flat percentage, or it can compound.
Credit: Credit is the ability to take delivery of a good or service before payment has been made.
Banking, Debt, Credit, and Currency
After a few months, things in our caveman community get back to normal and prices settle down and begin to stabilize. The community has grown to around 500 cavemen, all living in a happy little town made up of hunters and weapon makers, but now there are people who can make new these new things called “shoes”, and some people who can use wood, and Mammoth pelts to build these man-made caves called “houses”.
Bob and Tom make more and more clamshells trading their goods with Joe. Eventually, Bob starts getting worried about having to always carry his clamshells around with him. Once again, Joe comes up with an idea.
Joe tells Bob and Tom that, in exchange for two clamshells a month, they can leave their clamshells with him for safekeeping. Joe will write them a “debt note” on a piece of Mammoth leather saying how many clamshells he owed them. This way, they could go about their business without having to carry around all of those clamshells all the time, and when they needed their clamshells, they could simply bring the debt note back and exchange it. This was the birth of the very first bank.
Bob and Tom loved how convenient it was to not have all those clamshells in their pockets all the time. They told Mary and Jane about Joe holding their clamshells for them. Mary and Jane went to Joe and asked him to hold their clamshells also. Pretty soon, everyone in our little caveman community was letting Joe hold their clamshells for them. This got to be a problem.
Bank Vaults Have Gotten A Lot Safer Over The Years
See, there were so many people coming in and out each day, exchanging clamshells for notes, that Joe didn’t have time to get to everyone. This time it was Bob that had the brilliant idea. Bob said that instead of running to Joe every time they needed clamshells to trade for something, they could just trade the debt notes that Joe had given them, that way, they wouldn’t need to come to see Joe for clamshells all the time. Everyone agreed to just trade the debt notes, creating the world’s first debt-based currency.
Everything in our little community was going great now: people no longer have to carry around clamshells since they can just use the debt notes to trade for things, prices of things are fairly steady, and people are happy with how things are going.
Bob decides that he is interested in one of those “homes” that some people have. He goes and talks to Jeff, the caveman that makes these homes. Jeff tells Bob that he can build him a home, but that it will cost 10,000 clamshells. Bob doesn’t have that much, but winter is coming and one of these homes would be much warmer than his cave, so Bob decided to go see Joe for advice.
After hearing the situation, Joe comes up with a plan. See, Joe has all of these clamshells that he’s holding for people, and right now, they’re just sitting in a big hole. So Joe tells Bob that for a small fee (known as Interest), he will lend him the 10,000 clamshells that Bob can use to trade for the home. So Bob takes the 10,000 from Joe and gives it to Jeff for the home.
Bob has his nice warm brand new home and he’s in caveman heaven. He invites Tom, Mary, and Jane over for a Mammoth meat dinner. His friends all love his new home and want to know how he ever had enough clamshells to trade for it. So Bob told them about his deal with Joe.
The next day, Tom, Mary, and Jane all go to see Joe. Joe makes the same deal with all of them: for a small fee, he’ll lend them the clamshells to buy a home. Jeff finds out about Joe’s deal, and he decides that he wants to be the one making the extra money. So Jeff starts telling people that he will give them a choice: he will build them a house for one payment of 10,000 clams, or he will build them a house now, and let them to pay 500 clams a month for 24 months (2 years), for a total of 11,000 clams. This new option is called Credit.
So there you have it: a complete overview of the basics of the Economy. Over the course of the Economics For Beginners series, we’ll build on the things we’ve learned here. By digging deeper into some of the more complex aspects of the Economy we can see that they’re really just variations on the same underlying themes we learned about here.
I strongly advise you to bookmark this page and keep it handy, because you’ll be coming back to it from time to time.