Sunday, January 4, 2009

Economic theory, part the first

First off, let me say that I am not in any way a trained economist. This may be a significant disadvantage when formulating an economic theory, or maybe not. It's entirely possible that my ideas are taught to every economics student in Econ 101. It's entirely possible that they are taught as an example of how to be horribly, terribly, wrong. Of course there's always some small chance that I'll think of something both novel and interesting. I wouldn't bet on it myself, but I do hope that it will be at the very least interesting and thought-provoking.

Some time ago, I was thinking about the nature of value. I thought some about what goes into anything of value. I wondered where it came from. This led me initially past the labor theory of value. I thought that it would be possible to dissect the value of a thing down to its component parts, which are necessarily some combination of labor and the use of land. While true that all value derives from these things, it didn't seem particularly useful to think in those terms. The price of a thing is what the market will bear, and if you happen to be wandering across your small property and stub your toe on a diamond the size of a baseball, the market will bear a high price for it even though you've put very little labor or land towards it. On the other end of the spectrum, though you may spend weeks putting a fine polished shine on a ball of poop, unless you're the Mythbusters, the market will probably be uninterested.

It was at this point that I came to a realization. That realization is that I was conflating several related, but distinctly different concepts. These concepts I will refer to as cost, price, and value. The value of a thing is the most subjective of the three. At an individual level, it is what someone is willing to pay to acquire a thing. On a population level, it is a distribution curve of what people are willing to pay for a thing. This is related to demand, and when combined with what people or populations are able to pay for a thing is related to effective demand. On the other side lies cost, which is most closely similar to the labor theory of value. While value is defined on the side of the buyer as what he is willing to pay, cost is defined on the side of the seller as what he has already paid. For a person providing a pure service, it is the labor he provides. For the builder, the artisan, or the machinist, it is the cost of his raw materials plus the labor that he adds to them to craft his work. For the pure trader, it is the cost he paid for a thing himself, plus any labor he has expended in the process of executing his trades. The third component is price, and this is what the market will bear. From the perspective of the seller, he has the freedom to set this as he sees fit, but his realistic constraints are that it must not be higher than the effective value assigned to it by his potential buyers, else he will not be able to sell it. It must also be above his cost, else he will incur losses with each sale. This is a situation which cannot endure. With a population both of sellers and buyers, this will also form a distribution curve. A post for a different day will hopefully contain pretty graphs to illustrate this, as soon as I can find the right software to show what I see so clearly in my mind's eye.

Note that these three distributions form one point in an overall flow of value. In general, a flow of money in one direction will induce a flow of value in the other. This value may be created, consumed, or pass through an individual. So a thing may be created at a labor cost to an individual, who will then assign it a price according to the value buyers place on it. That price then becomes the buyer's cost, which he will use to assign his own price. This flow in its own right has interesting analogs to electrical flow. When a current flows from one end of a wire to another, electrons do not move the entire length of the wire. Similarly, a flow of money in one direction (note that a particular dollar, much like an electron, does not make the whole trip) will induce a flow of value in the other, but that value does not necessarily flow all the way through. There is a certain flexibility in the value flow, corresponding the the capacity of each individual in the chain for saving and debt, but generally a person will consume value at the same rate that he creates it.

Note also that I use the term person loosely. I say individual, but is could be a family, a company, a town, or a nation. I suppose in theory you could go the other direction and analyze cellular economics, but as metabolic processes operate purely on the barter system, things become a bit more muddied and are probably best left to biologists and chemists.

And finally note that there is no particular point that I am trying to make here, it's merely a bit of insight as to how I see economics, and a reference that I can use in later posts on related topics.


LWO said...

Very good. If you're so inclined, go have a peruse of

Some few comments -
value is, as you noted, in the eye of the beholder. It is not an intrinsic property of the thing being considered, else there would never be any question as to price or trade.

"...consume value at the same rate as it is created." I disagree. Value is a perception, an intangible, and cannot be 'consumed'. There is no limit to the amount of value I can invoke at will, merely a limit on my ability to demonstrate it with money, time, or the ultimate measure of time, my life. Likewise there is no limitation on my ability to change my Value arbirtarily, at whim. You could try to define other terms for this 'Stuff' you're trying to find, the Goo which flows the other way from money, but 'value' is close enough for now. If it were consumed then the universe would be in a 'steady state' with a balanced equation and (this is the important part) nobody's standard of living would ever increase. The outward evidence of value is wealth, which is the increase in the standard of living. As this is being noticeably improved over time the equation must not be balanced - and this is a Good Thing. This is the magic which most economists completely fail to understand: it is NOT a zero-sum game.

Lazlo said...

Value may be intangible, but it can be consumed, just as it can be created. Value is not an intrinsic property of an object, but instead is an intrinsic property of the relationship of an individual to a good or service. So the transformation of a good from one form to another, or a difference in the quality of a service, will make either a positive or negative difference in the value any individual places on that good or service. With reference to a population, this manifests itself as a difference in the integral of the percieved value over the population, constrained to the effective demand. A change in the nature of a good will effect a change in the distribution of rational pricing. If I buy an apple, I collapse the cost distribution to a single point represented by the price I paid. The value distribution among the market for people who may want to buy that apple may well include people who are willing to pay more than my cost. It's rational for me to resell that apple to one of those people at a profit. Presumably, those people did not have access to or knowledge of where I bought my apple, thus providing me an opportunity for profit via arbitrage. If I polish that apple, or bake it up with some cinnamon and sugar, then it's very possible that the population of those willing to pay more than my cost will expand, making it rational for me to increase the price I charge. Thus, value has been created. If, on the other hand, I eat the apple and pass it through my digestive tract, then the distribution of how the population will value what remains is almost certain to fall entirely below the cost I paid for it, thus meaning that value has been consumed.

So, the universe isn't in a steady state with respect to value, because it can be both consumed and created. There is an important thing to note that I failed to emphasize. Money flows in the opposite direction to value, and is also a unit of measurement for value, but the flow is necessarily asymmetric. Given freedom, no one will pay more money for something than the value they place on it. They will, however, pay what the market demands if the value they place on the good is larger.

I can easily visualize the graphical representations of these distribution graphs in my head. Someday I hope to find software that will let me share those mental images with everyone else. So far, that search has been fruitless (although, in all fairness, it hasn't been a particularly aggressive search...)