Economics in a Nutshell

John Doe
9 min readJan 17, 2023

Oxford languages provides the following definitions for “economics” and “economy”:

economics: the branch of knowledge concerned with the production, consumption, and transfer of wealth.

economy: the wealth and resources of a country or region, especially in terms of the production and consumption of goods and services.

What’s the difference between being rich and being wealthy? Easy: someone is rich if they have a lot of money and someone is wealthy if they possess a lot of value. Wealth is to value as rich is to money.

Money is a proxy for value. Money is not inherently valuable by itself, it’s only valuable because people universally recognize it as a stand-in for value. This was true when we were on the gold standard and remains true today with fiat currencies.

Value is a vague, qualitative concept that is subjectively determined (one man’s trash is another man’s treasure). Money and prices, on the other hand, are concrete, measurable and objective in the sense that they don’t (usually) change from person to person. It makes sense, then, that economics focuses a lot on money, markets and pricing and optimization within these domains. Most of the effort is spent on these optimizations while the value-related portion is hand-waved away with the assumption that people are “rational agents”, whatever this means.

Not enough time is spent really understanding value, which is odd considering that economics is centered around the creation, distribution and consumption of value, not money. Why are we optimizing when we don’t even know what we’re optimizing for? Valuation is more fundamental than optimization, but economists seem to enjoy their mathematical models far too much to consider what is actually important. I digress.

From Bartering to Money

Before there was money there was bartering. Bartering is the act of directly exchanging one good or service for another. Bartering only works because each party values what they are receiving more than what they are giving up.

Bartering is inefficient for two reasons. First, it requires closed loop transactions where each party receives what they want at the same time. Scaling bartering beyond two parties quickly becomes intractable because of the amount of coordination needed.

The second reason is that there is no standardized way to express the value of any good or service. Because of this, each individual transaction requires both parties to evaluate the other person’s goods or services and then agree on an appropriate ratio to exchange, which takes a nontrivial amount of time and energy. You can’t use an amount like “5 dollars” because currency doesn’t exist yet. The best you can do is list all the different goods and amounts of these goods you are willing to trade your item for. For example, I’m willing to trade this chicken for five potatoes or three sacks of wheat or a wagon wheel, etc, etc.

Money breaks the closed loop requirement of bartering by acting as a stand-in for value. Now, instead of a lot of small closed-loop transactions, money allows value to flow in any direction without ever needing to close the loop. The best way to understand this is by making money invisible. Let’s say there’s a farmer’s market where people are buying groceries. If money is invisible, it looks like all the vendors are giving away their valuable goods to the patrons and are happy to do so, which is something that would never happen in the age of bartering. Now these vendors go out and buy meals at restaurants and get haircuts at barbershops and buy books at the bookstore, and since money is invisible, these shops look like they are doing it for free. This continues over and over again and everybody is fine with it as long as they believe that they can exchange the money they receive for valuable goods and services that other people provide. Money liberates the exchange of value and, as a result, makes it possible to do a functional value exchange with an unlimited number of parties with minimal overhead.

Money also serves as a standardized interface for conducting transactions. Now you can set a price on your goods and services that can be communicated and understood by everyone else. This eliminates the evaluation and communication overhead that comes with every bartering transaction. This, in turn, opens the door to the creation of matching markets where bids and asks are instantaneously matched and executed. At the faster end you have stock exchanges, but any store is also a matching market where the store posts all of the asks (prices they are willing to sell goods for) and the shoppers will buy items if their internal bid is at least the price on the shelf.

Markets and Liquidity

Markets existed in the age of bartering and in the age of money. The only difference between the two is the efficiency.

Markets facilitate transactions by providing a central location where buyers and sellers can be matched and transactions can occur. Markets that use money (basically all markets nowadays) also do the job of pricing goods and services according to supply and demand. There is only one market price for a good or service, and that is the price at which the last transaction occurred. Price is a proxy for value, and if each person values a good or service differently, that means that each individual’s perception of the market price varies. Someone who values something a lot is much more likely to transact at market price than someone who doesn’t value that same something very much. The market price, seen through this lens, is a collective approximation of the value of something calculated as a weight average of each market participant’s subjective valuation of that said something. The weight in this weighted average, for buyers, is how much money the buyer is willing to spend in the market for this good, and for sellers, is how much of said good they are willing to sell on the market. Larger players will have a proportionately larger effect on the market since they transact for larger quantities.

In an ideal economic system, money and price would correspond perfectly with value. But, as with all proxies, money and price are an imperfect stand-in for value. The goal of economic system is make money and price approximate value as accurately as possible in every way. For example, the system should have people who produce twice the value get paid twice the amount of money. On the consumption side, something that is twice as valuable as something else should cost twice as much. Market economies are not perfect in this, but they do a better job than any other economic system that people have used.

When labor is accurately priced, people are incentivized to use their skills to produce value in the most efficient way possible. This is the idea behind comparative advantage. Put simply, if person A can make 10 hats an hour or 5 shirts an hour and person B can make 5 hats an hour and 10 shirts an hour, then the best to do would be to have person A dedicate their time to exclusively making hats and have person B only make shirts. Afterwards, they can trade, and everybody ends up with more value. Person A has a comparative advantage when it comes to making hats because he can make them for the opportunity cost of half a shirt, compared to Person B’s opportunity cost of two shirts. Person B has a comparative advantage when it comes to making shirts because his opportunity cost for making a shirt is lower than Person A’s opportunity cost for making a shirt (half a hat vs two hats, respectively). Comparative advantage applies to any entity that can produce value, which includes countries, companies, teams, people, etc.

When labor is accurately priced, people are incentivized to use their skills to produce value in the most efficient way possible, which naturally results in people specializing in areas in which they have comparative advantage, which translates to more value being produced. This is the magic of a functioning market economy — get the first thing right, and everything else will follow.

When goods and services are accurately priced, producers will naturally gravitate towards areas that are underserved (demand > supply, price is high) and move away from areas that are overserved (supply > demand, price is low). This allocation process happens naturally since companies and entrepreneurial individuals are always looking to make more profit, and this happens in areas where prices are high. Entrepreneurs also try to serve areas that aren’t being served at all that have potential value.

Currency, Central Banks, and Interest Rates

I mentioned earlier that money is proxy for value. At the macro-scale (country-scale), Central Banks are responsible for controlling the money supply. Their goal, in simple terms, is to make sure that the money supply tracks the amount of value being produced in the economy. One way Central Banks monitor the money supply to value ratio is through some sort of consumer price index which tracks the prices of certain goods and services over time.

If the money supply increases faster than the value being produced in an economy, inflation occurs. In this situation, money is worth less as time goes on (i.e. each unit of currency corresponds to less value), which means that you need more money to buy the same goods and services than you did yesterday. Inflationary environments encourage people to spend rather than save since they can get more value for their money today than they can in the future.

If the money supply increases slower than the value being produced in an economy, deflation occurs. In this case, money is worth more as time goes on, which means that you need less money to buy the same goods and services than you did yesterday. Deflationary environments encourage people to save rather than spend because they can get more value for their money in the future than they can today.

Inflation and deflation both show dangerous self-reinforcing behavior once they progress past a certain point. Central banks and governments tend to prefer a little bit of inflation to deflation, all things held equal, since a bit of inflation encourages capital flow (i.e. spending) which has a stimulating effect on the economy. Contrast this with deflation, which causes capital pooling (i.e. saving) and has a sedating effect on the economy.

Central Banks combat inflation by increasing the risk-free rate and/or selling off assets on their balance sheet (quantitative tightening). The increase in the risk-free rate makes borrowing more expensive, which slows down the rate at which loans are taken out, and by extension, the rate at which the money supply increases. This has a dampening effect on the economy, and in some cases, will lead to a recession. Selling off assets (usually bonds) has the effect of decreasing the money supply since the cash collected from the sales will be sit on the Central Bank’s balance sheet instead of circulating in the economy.

To combat deflation, Central Banks lower the risk-free rate and/or buy up assets (quantitative easing). Decreasing the risk-free rate makes borrowing cheaper, which increases the volume of borrowing and the rate at which the money supply increases. This has a stimulating effect on the economy. Central Banks will often lower rates to stimulate the economy in times of recession or depression. The risk-free rate, for the most part, is at least zero, except in cases like Japan where deflation is such a problem that the risk-free rate is chronically negative. Buying up assets (usually bonds) has the effect of increasing the money supply since the cash used to pay for said bonds will start circulating in the economy after the sales.

Economic Roles

There are three main roles that a person or organization can play in a large, developed market economy. The first is the role of manager. The two large managerial players are the Government, which dictates and enforces the laws that markets and businesses must adhere to, and the Central Bank, which is responsible for managing the money supply.

The rules that the government creates has many purposes. Some of the most important are:

  1. Ensure a fair playing field for market participants (e.g. antitrust, anti-corruption legislation)
  2. Protect consumers (e.g. FDA, NHTSA)
  3. Protect employees (e.g. minimum wage laws, child labor laws, OSHA)
  4. Protect domestic interests (e.g. tariffs)
  5. Build out and incentivize long-term strategic economic developments (e.g. infrastructure projects, national defense, etc)
  6. Price in externalities in order to combat Tragedy of the Commons (e.g. environmental incentives, carbon taxes, etc)

These purposes are essential modifications that need to be made to market economies in order to make them work in the best interests of society. You can think of them as blind spots or weaknesses that markets are unable to effectively address.

The second role is that of the capital allocator. These individuals or organizations are responsible for allocating capital in manner that produces the the highest returns for their stakeholders. If labor, goods and services are priced accurately in an economy, then capital allocators, in their pursuit of returns, will also help produce more value as a side effect. Examples of capital allocators include venture capitalists, hedge funds, investment banks, and high-net worth investors.

The third economic role is the value-producer role. This role encompasses anyone whose work is directly creating value for others in the economy. Think of fast-food workers, auto mechanics, software engineers, etc, etc. It’s important to note that you can be both a value-producer and a capital allocator at the same time. They are not mutually exclusive. One would hope, however, that the role of manager is mutually exclusive from that of capital allocator or value producer, but this is often not the case (see: regulatory capture).

--

--

John Doe

Processing information, stacking concepts. Writing this down so I don’t keep thinking about the same things over and over again