Thursday, July 20, 2017

What is an Institution?

Find out in my new post at the NDSU Center for the Study of Public Choice Blog.

Tuesday, February 21, 2017

The Emergence and Functions of Money 2.0

To the lay observer, the existence of money appears to be a given, and this is if they even notice money’s peculiarity. Money is a good, but unlike other goods, its primary use is as a medium of exchange. In the pre-modern era, money was typically linked to a commodity, but in the modern financial system, this is no longer true – at least not for base money. So how does money become an object of its own, delinked from any use value? How does money arise at all?

Given that humans preexisted money, there must have been a time where money did not exist. This is consistent with the framework that we have built over the last several weeks. Remember that analysis starts with agents. These agents have preferences that are revealed as they engage in exchange. Implicit in this exchange is the existence property rights. Every agent has opportunities to engage in entrepreneurial action. Our agent acts to attain profit. She imagines that she can transform the world from its present state into one that she prefers more greatly. She forms an expectation that she will use to frame and guide her action. The agent may prove successful and attain the profit or may break even or even incur a loss. In typical fashion, we can extend this concept to exchange. Two agents, both looking to improve the state of their existence, notice that each has a good desired by the other. It so happens that each wants the good that the other holds so they exchange the goods. Each has improved his or her lot, although we cannot be sure by how much exactly as there is no such thing as a cardinal utility measure – not even for a single agent. We must take agent action at face value and accept the action as a contextually constrained expression of the agent’s preference.

Barter is easy to accommodate in the model when the agents lacks geography. Action, however, always occurs at a particular time and place. The agent interested in a trade, let’s call him agent A, must find another agent, agent B, who owns the object of desire and who is interested in trading it for something owned by agent A. Often, this double coincidence of wants fails to arise. The agent can continue looking for a single trading partner, or he can partition his work. Instead of finding only a single agent, he can find a good that is demanded by agent B and trade that intermediate good for the desired good. Over time, the agent might realize that there are one or several goods that most easily accommodate this indirect exchange. First several other agents notice this wise idea and begin to copy the innovation. A small number of goods come to be recognized as having value in exchange in addition to value in use. These goods are different forms of money.

As we have seen, money does not arise by the plan of a single individual. It arises without intention. The goal of agent A was simply to find a good desired by agent B. There is no need for agent A to expect that other agents will adopt his strategy. His goal was simple. As the innovation is copied, the commodity becomes a network good. It gains value because other agents are willing to use it in indirect exchange, and therefore, charge prices in terms of the intermediate good. The good that becomes money comes to serve as a numeraire in which prices are denominated.

What makes for a good money? History provides an answer. Societies have tended to select money that meets 5 criteria. Money must be
1. durable
2. easily divisible
3. relatively scarce
4. highly saleable
5. portable.

These qualities promote the function of money. With these criteria more or less present, money can serve as:
1. a medium of exchange
2. a store of value
3. a unit of account
4. a standard of deferred payment.
Notice that the criteria for money relate to its functions. Saleability and portability allows money to function as a medium of exchange in the first place. What good is a money that is difficult to carry? Increased portability makes a money more easily saleable and more broadly acceptable. Durability and scarcity promote money’s function as a store of value. Divisibility is closely linked to money’s role as a unit of account. Prices, denominated in the unit of account, are more easily accommodated if money can be divided into homogeneous units. Given a common unit of account, agents can also lend money to one another. This allows an agent to attain a good that she otherwise could not afford or would be unable to borrow. Thus, money becomes a standard of deferred payment.

The development of money represents an innovation in accounting. A common standard or standards of measure allow for an approximation of the socially determined value of a good. Since prices are denominated in a common unit of account, the value of different goods, as determined in light of the demand of consumers and cost of supply, can be compared objectively. These prices represent the quantity of money a good can fetch if it is sold on the market. This allows producers to compare costs and revenues so that they can be certain of the magnitudes of their gain or loss.

These prices fluctuate according to changes in the quantity demanded at a given price (shifts in the demand curve) or as quantities available at given prices fluctuate (shift in the supply curve). They also change if either of these factors are expected to change. Thus, prices reflect not only present conditions but also expected changes in these factors. Since prices reflect information about agent valuations, they increase the accuracy with which agents can account for the value of their goods. This promotes an allocation of goods that reflect needs of all agents the preferences and budget constraints of those agents. With the addition of money, our model contains the building blocks requisite for economic calculation and widespread patterns of exchange.

Market regulation of the quantity of money

Just as money emerges from within a market dependent upon barter exchange, the quantity of money is also determined by market forces. Imagine that in some market, oats become the commonly accepted medium of exchange overnight. This change means that any person who buys or sells goods is willing to let money represent the other half of the exchange. A farmer who sells an apple use negotiates a price in terms of some weight of oats. He buys other goods using these same oats. 

Suppose that a community recognizes, overnight, that oats can now be used as money. Instantly demand for oats will increase as agents understand that oats can be exchanged for other goods. That is, oast not only have a use value – they can be eaten – but they also have an exchange value – they can be used to acquire other goods. The new price of oats, p1 (Figure 1) represent the combined use and exchange values. The original price, p0, represent the use value of oats. The difference between these two (p0 – p1), represent value derived from exchange. Note that if the supply curve was perfectly inelastic at q0, that the exchange value would be reflected by price implied at the intersection of Q0 and D1. For this example, the exchange value of oats in the short-run will be higher than the price reached in the long-run equilibrium.

The higher price sustained by the use of oats as medium of exchange incentivize greater production of oats. If the price is pushed high enough, it can also incentivize the development of technology that reduces the cost of oat production. Something similar occurred at the end of the 19th century when a relatively high price of gold incentivized the development of cyanide extraction process. For oats, this may include the development of new irrigation techniques or systematic use and breeding of the most productive strains of oats, among other possibilities. If the technology successfully reduces the cost of producing a unit of oats, the cost of supply falls. We represent this by shifting the supply curve to the right (Figure 2). Suppose that oat farmers suffer a drought one year. What will happen to the price of oats? In the case of a drought, the cost of supply increases. The supply curve for oats will shift left and the value of oats will increase.

Figure 1

Figure 2


The price of money
You may ask yourself, if oats are money, how do we determine their price. For any money, its price is what it exchanges for. If a quart of oats trades for 2 apples in equilibrium, then the price of a quart of oats is two apples. Likewise, if the same quart trades for 3 oranges, then the price of a quart of oats is also 3 oranges. Likewise, the price of an apple is 1/2 quart of oats and the price of an orange is 1/3 quart of oats. Money has an array of prices. Thus, the price of money is whatever it can exchange for. What we usually mean by the price of money, however, is the average price of money. This is often referred to as its purchasing power. Typically, we refer to the price level, which is the inverse of the purchasing power of money. A price index considers all exchanges for each type of good. Ideally, the price of each category of good sold is weighted according to the total number of goods exchanged. In reality, the basket of goods and weights of these goods change overtime, so there exists no perfect estimation of the price level and, by implication, the purchasing power of money.



[1] Another term commonly used is the purchasing power of money.

*Expanded from The Emergence and Functions of Money

Specialization and the Extended Order

In earliest society, the number of jobs that were available to men and women were limited. They were also strictly allocated on the basis of gender. Goods were allocated amongst a community according to one’s position in the hierarchy. As society grows larger, this structure of cooperation is difficult to maintain. Groups tend to divide at Dunbar’s number, which lies somewhere between 150 and 300 persons. When groups split in two, there will likely remain contact and cooperation between the groups, but as groups grow more numerous they become more difficult to manage. The structure of society must become more sophisticated if many parts are to form a coherent whole.

In a world where resources are scarce, humans must necessarily be value creating if they are to survive. At its core, this value consists in the provision of goods that promote survival. In pre-modern society, this may consist only of finding goods and shelter. As society grows more complex, many agents are expected to acquire more skills and means to augment their labor.  One person’s livelihood may depend on his Volkswagen van to deliver mail in rural Nebraska. The van is a means to providing the income that maintains his life. Others must develop specialized skills, a form of human capital, in order to offer a service that generates income. Plumbers, lathe operators, auto mechanics, programmers, and many other fall under this category. Blue collar and white collar jobs typically fall within this domain.

Specialization requires the development of technology and capital that embodies this technology. To move from a society of hunter-gatherers to a society of farmers, the technology for farming must be developed and spread. One cannot farm without knowledge of the seasons and of planting. One must also have available means of protecting one’s crops from hungry animal and thieves. All of this is technology that would otherwise be unnecessary and relatively costly in a world where food is abundant. As regions become more crowded, inhabitants face two options: move to regions with fewer people or begin farming. Hunter-gathering groups cannot remain in these areas. Herders are forced to the outskirts of this society as farmers develop land for intensive cultivation. The movement from a life in transit to a relatively sedentary existence enables the formation of a governing structure that is also stable. This may not happen immediately, but it does not take long. We will discuss this further in the next lecture.

Specialization and Technological Development

Specialization also enables the development of technology and capital. Imagine two castaways stranded one an island. We often use the story of Robinson Crusoe in this manner. Crusoe, stranded on an island, must find the means to satisfy his desire for food and shelter. He cannot work simultaneously to achieve both. Thus, he must spend some portion of his time fishing or harvesting coconuts and another portion to dedicated to building and maintain shelter. As long as Robinson Crusoe is alone, it is difficult for him to develop means for either. When Friday arrives on the island, he brings with him similar demand for food and shelter. Yet, the economic problem becomes more complex and, therefore, provides more possibilities. If Friday enjoys fishing, he can spend his time gathering food in this manner while Robinson Crusoe concentrates his energies on providing shelter. Perhaps Friday can catch enough fish for Robinson Crusoe in 6 hours. If he likes, he can spend the rest of the day resting. However, since Robinson Crusoe is working on the other side of the island, he may feel an obligation to contribute to the team so as to leave everyone better off. Suppose that Friday would like to be able to catch more fish in less time, so he spends his free time trying to create a net. At first, this is a laborious process as he lacks the knowledge for this, so he must spend time experimenting. Perhaps Friday needs two months two develop a proper net. Once he has discovered a successful strategy for building nets, he dedicate less time to fishing. Further, the time taken to create a new net will be less as it will not require the initial costs of discovery that Crusoe first faced. Now Crusoe can spend his time searching for new food sources. Or if he would, he can work with Robinson Crusoe to improve their shelter.

Once shelter is built, Robinson Crusoe and Friday will need clothes to stay warm at night. If the productive potential of both persons for each good is given, we can perform some simple operations to understand how specialize improve outcomes in a world of exchange. Imagine that, if Robinson Crusoe and Friday specialized, their maximum production of either good is as follows.
Table 1
Production Possibilities
Frontier

RC
F

Clothing
20
20
Fish
10
30

If both Robinson Crusoe and Friday split their productive energies evenly between the two goods, they will produce the following amounts.
Table 2
Production absent
 Specialization
and Trade

RC
F

Clothing
10
10
Fish
5
15

This is not the most efficient outcome. Robinson Crusoe must sacrifice 2 units of clothing for every fish he catches, while Friday sacrifices 2/3 units of clothing for every 1 fish he catches. Inversely, he sacrifices 1.5 fish for every 1 unit of clothing he creates. If they were to specialize, they would produce as follows
Table 3
Production
with Specialization
and Trade

RC
F

Clothing
20
0
Fish
0
30

Robinson Crusoe will be willing to trade up to 2 pieces of clothing for 1 fish. Let’s assume that Friday is willing to trade fish at a price of one piece of clothing, which he would surely accept because the opportunity cost of producing one unit of clothing himself is 1.5 fish. That represents a discount of 1/3 for Friday. In the final allocation, Robinson Crusoe has 5 more fish than he could produce on his own. Friday also has 5 more fish. As fish provide positive utility to both parties, we observe a pure pareto improvement as a result of specialization and exchange.

Table 4
Final Quantities
with Specialization
and Trade

RC
F

Clothing
10
10
Fish
10
20

If both Robinson Crusoe and Friday develop technology to improve their efficiency, we may see their production possibilities frontier shift out. We could perform the same exercise and see that, assuming that specialization enables the development of technology, the situation of both parties will continue to improve so long as technological advancement is possible.

Table 5
New Technology Shifts
Production Possibilities
Frontier

RC
F

Clothing
40
20
Fish
10
50

One change enables another. The development of a more cost efficient form of production can support larger populations and more complex societies. Before this change, it may be difficult for metallurgists to survive. To the extent that one can develop and maintain a social position for oneself with a specialization such as this, he can maintain his well-being through production and exchange. Likewise, this change in society opens the opportunity for carpenters who have specialized knowledge of constructing and repairing buildings. Underlying this change is the fundamental principle we identified early on: humans act to improve the state of the world as they perceive it.

Decision to action occurs in light of the costs and benefits that such action is expected to generate. Humans rarely imagine radical change. Even that thought be radical is usually marginal in light of the present state. Thomas Edison’s discovery of the light bulb, while unexpected by many, required a combination of elements that were readily available to him. This innovation required a search through the vast space of possibility that exists at the fringes of existence. Once found it may enable and encourage many other innovations that were not previously possible. The development of the light bulb, for example, made valuable the provision of electricity in cities. This further provision opened up many opportunities as it allowed for technical development and specialization that would have otherwise been impossible.

Comparative Advantage and Opportunity Cost

So far, we have been thinking of action solely in terms of the exploitation and creation of profit opportunities. If we also integrate the notion of the opportunity cost that inherently exists as a result of living in a world of scarcity, we add another dimension to specialization. Ricardo first spoke of this dimension as comparative advantage. Consider the job of Stephen Curry who plays for the Golden State Warriors. Stephen Curry is a phenomenal leader and basketball player. He seems to make best use of his talents playing for the Golden State Warriors. Curry is not just a talented player, his presence is a unifying force that has helped move the team to win a championship and a heartbreaking miss last season. The opportunity cost of Curry’s participation with the Golden State Warriors is likely participation with another team. The value he creates for the Golden State Warriors is substantial enough that the team has retained him since his entrance in 2009. Although Curry would likely be valuable for any team on which he plays, he has a comparative advantage playing for the Golden State Warriors.

This becomes more obvious if Curry were to change his occupation altogether. Curry may be a fantastic manager. When he graduated from college, he could have entered a field that allowed him to exploit his leadership ability through management. Even if Curry was one of the best managers, it would be difficult for him to surpass his current pay and other benefits he receives playing for the Warriors. This is to say that Curry may have an absolute advantage in comparison to others both in his management ability and his ability on the basketball court. Market prices, however, inform Curry that the most valuable use of his skills will leave him playing for the Warriors, even if he had an absolute advantage as a manager and as a basketball player, he has a comparative advantage in playing basketball.

Comparative advantage allows us to explore areas that may, at first glance, seem to be a source of waste or laziness. Bill Gates, who is estimated to be the world’s wealthiest person in 2017, generates a tremendous amount of value with his time. It makes little sense for Bill Gates to spend time preparing meals or cleaning his own home. Every moment he spends engaged in this activity, he could be dedicating to create more value elsewhere. Cleaning and cooking is especially costly for Bill Gates. He is better served by purchasing cleaning and cooking services than by performing these tasks himself. He may choose to do this simply out of enjoyment of the activity or belief in the personal enrichment from such activity. In terms of value as measured by money prices, he is incurring great cost if he chooses to do so.


Development of specialization that arises due to comparative advantage plays a significant role in the provision of knowledge in society. Specialization itself allow individuals to develop knowledge of a particular category of activity. Gold refining processes could not be developed unless individuals were allowed to spend their time and creative energies developing them. The same can be said of computer processors, means of transportation, mass production, and so forth. The development of cost-reducing technology that allowed much farmland to be tended by far fewer people has allowed individuals to invest their labor in other ventures. It is no coincidence that, within a century of this shift, we live in a world that is dominated by technology. The pace of change appears only to increase as freedom to develop technology and organization also increases.

(Table structure borrowed from Don Boudreaux's article on comparative advantage.)

Friday, February 10, 2017

Entrepreneurship: language, knowledge, and networks

A task of human action and organization is to reduce uncertainty to risk, an event whose outcome that can be predicted probabilistically, and to adapt in the face of uncertainty that is irreducible (Knight 1921). All action entails uncertainty. One does not know what will happen tomorrow. If we lived in a world where developments were perfectly predictable, coordination would be a simple task. Not only can we not be certain whether or not we will meet the fate of the dinosaurs in five years’ time, we cannot even be certain of the actions that other people will take. We cannot look into their minds. We can only develop relationships and communities that help reduce this uncertainty. The task of the entrepreneur is especially complex for this reason. He must successfully navigate an environment where consumer preferences are changing and where cooperation is not guaranteed.

Successful entrepreneurship is a task of sensing. This requires two key components: a model that coherently identifies and predicts the environment and accurate information that is to be processed by the model. We gave some examples of this in the previous post. Models used by successful entrepreneurs are likely difficult to explicitly identify. Some combination of intuition and explicit beliefs feed into entrepreneurial decision-making. While we cannot identify a particular model that makes an entrepreneur successful, we can consider some components that lead to coordination which the entrepreneur must learn to navigate if he is to be successful.

We have seen that prices lead to coordination, but this is only the case if non-price information can be integrated into prices. There is a variety of information to be integrated. Changes in physical conditions are primary. The emergence of a new form of capital provides opportunities for use. Changes in climate must be predicted if farmers are to make decisions that cohere to the environment and, thereby, maintain substantial yields. A more difficult task is navigating the social environment of other actors who themselves are guided by models and information that the entrepreneur knows only in part.

Humans are social animals. It should not be surprising that we must spend a tremendous amount of energy to reduce uncertainty within this domain. If an entrepreneur is to engage in a venture, he must feel confident in his trust of his business partners. Building trust between partners is a matter of ingraining patterns of action sufficiently that all action evidences a level of mutual concern sufficient for the end toward which cooperation is aimed. The greater the volume of interaction and the number of ways in which one interacts with another, the greater the need for mutual trust. Action that can be interpreted as a violation of trust makes future cooperation less attractive for the observing partner. Maintaining trust is a complex task that requires continual evidence of commitment to the well-being of the other and a lack of evidence to the contrary.

The primary way in which human agents maintain commitment is through the practice of a complex array of overlapping games whose meanings reinforce one another. These are institutions, but this term is not fully descriptive in that there are a multitude of these and that every social milieu includes its own unique mix of overlapping patterns: these are language games, which I will refer to as social games when appropriate or, simply, games (Wittgenstein 1953). The game of largest extent is the game of market exchange (Bloor 1995; Koppl 2002). In the basic form of the game of market exchange, agents own property and themselves and are able to exchange that property and services rendered by it for other goods. If existing barriers to competition are relatively small or non-existent, prices of like goods will tend to converge to the same value when controlled for transaction costs, which include costs derived from distance, search, administration, and the like.

As has become especially obvious to those who purchase goods online, the game of exchange spans groups and larger collectives. Persons from an Amish community in Pennsylvania are able to purchase materials from India, even though the internal functioning of the group is not oriented toward market exchange. Groups that may seem impervious to markets inevitably participate in them. Inclusion in the market is welfare improving even for these groups. When the risk of fraud is low, the game of exchange leads other players in it to promote the well-being of other players in the game. The larger the extent of the market, the more benefits consumers receive. Cost reducing division of labor and improvements in product quality are promoted by the increase in the number of players, and therefore, competition and the reduction of the cost of specialization.

There are many other games that occur within and between groups who play the game of exchange. The meanings embedded in sets of overlapping games reinforce the place of each actor and normative beliefs held in the group and play a significant role in interpretation of action. Whether the group hierarchy is rigid or fluid, of great power distance or small, relatively oppressive or less so, meanings implied by games reinforce that hierarchy as it exists. These games themselves tend to be adaptive to needs in the group and drives of its members. If some group participating in a game larger than its membership find that they are oppressed by another group, discontent expressed through action may lead to a reduction of the weight placed on it by the more powerful group. In politics, the latter group is thought of as the ruling class (Mosca 1939). Such implicit agreements arise in the course of gift exchange and other symbolic interactions in many early societies (Bordieu 1980). While they may alleviate the burden of the underclass, they also reinforce the existing hierarchy. Not all games are embedded in systems of oppression. In fact, it is difficult to identify a system as purely oppressive or something else, especially if there is no obvious path to improvement for all. Sometimes, societies will be stuck in suboptimal equilibrium, much as most of human society was stuck before the industrial revolution and dramatic political change that surrounded it.

Social games tend to be confined to networks of individuals who are part of the in-group. Consider students from secondary school. They all play the same game concerning the schools schedule. They obey the bells and their meanings. Failure to obey may create problems for the students as rules require the students to show up at certain places at certain times. Inside of this larger game, many other games are played. Students form groups whose meanings tend to be contained in the group. One group may occupy a table at lunch and tend to follow a rule that all remain seated there during lunch. A member who fails to adhere to this rule may receive strange looks. Other groups may prefer to stand and do not demand continual presence. Those in the group may feel secure with some minimum threshold of participation from others that is not quite as burdensome. Groups may feud between one another within a school and yet, members from these groups may all come together in larger events like sports games and musical competitions where they face other schools. Most students successfully navigate these interwoven games. Schools with students who are adept at this and therefore able to cooperate at larger scales are more likely to excel in these bigger competitions. We would also expect that schools where groups tend to hold less animosity between one another will also excel as the population forms a more coherent whole.

Coordination through games does not happen automatically. Humans are often predisposed by their passions to animosity toward those who are not within their own group. Entrepreneurs help bring together groups such that plans of members more coherently overlap. Successful social entrepreneurs are able to work between groups, filling structure holes (Burt 2000). The holes represent network structure where two agent or groups of agents are otherwise distinct from one another. There is no member in one group who shares membership with the other. Due in part to their congeniality toward both groups and their ability to speak the language of both groups, social entrepreneurs who fill structural holes are able to realize profit opportunities that are otherwise unavailable. Not only must such a person speak the language of both groups, but he must do so in a manner that, in the least, implies no ill will or deception toward his partners. A failure to do so will likely limit the success of the entrepreneur as well developed groups are especially sensitive to potential for fraud. In the ideal case, his actions reinforce the meanings of both groups to the extent that it is possible, though this becomes an increasingly difficult as the magnitude of animosity increases between groups. This may be why early merchants were held in disdain.

Entrepreneurs who are successful at navigating these games are able to foster a world that they would prefer to live in. The better their ability to navigate the social milieu, the more they can reduce costs of organization and find access to resources that are otherwise unavailable. Following Foss and Klein (2012), entrepreneurship exists as agency that controls some set of resources, using the available bundle to exploit profit opportunities and create new ones in the process. Navigation of social context potentiates profit opportunities. Thus we may look to firm operation to better understand the role of language and communication in entrepreneurship.

Efficiency increases lie in wait within firms whose divisions lack knowledge of one another. Language common to the firm must facilitate the transmission of information within it. Channels must exist between the parts of the firm in order to minimize information costs. Kenneth Arrow (1974) observes,
An organization can acquire more information than any one individual, for it can have each member performing different experiments. Thus, the limitations on an individual’s capacity are overcome. But as always there is a price to be paid . . . The information has to be coordinated if it is to be of any use to the organization. (52, 53)
He continues in regard to coordination of diverse knowledge within a firm,
. . . we have seen that the organization’s gains from increasing scale are derived by having its members make different experiments, that is, by specialization. As we have seen in the last chapter’s discussion of the economics of information for the individual, this means the members will be accumulating differing types of skills in information processing, learning (acquiring [human] capital), in the areas in which they are specializing and unlearning elsewhere. As a result, communication among them becomes more difficult (as academic specialists are learning), and the codes used in their intercommunications have to become more complex. (55)
The development of unique language within a group promotes specialization while increasing the cost of integration of this dispersed knowledge. Nonaka (1994) observes that creations of redundancies within a firm can facilitate the sharing of knowledge between divisions.
Rotation helps members of an organization understand the business from a multiplicity of perspectives. This makes organizational knowledge more fluid and easier to put into practice. Wide access to company information also helps build redundancy. When information differential exist, members of an organization can no longer interact on equal terms, which hinders the search for different interpretation of knowledge (29). [emphasis mine]
Perhaps ironically, the increased flow of knowledge and potential for creativity, while being welfare promoting, also increases uncertainty as new possibilities for the course and ends of production arise at a faster rate.
Creative chaos is generated naturally when the organization faces a real ‘crisis’ such as rapid decline of performance due to changes in technologies or market needs, or the realization of a significant competitive advantage on the part of a rival firm. It can also be generated intentionally when leaders of an organization try to evoke a ‘sense of crisis’ among organizational members by proposing challenging goals (28).
So long as redundancies in knowledge exist, members understand how their work affects one another creating plans that tend to dovetail. This requires a “deep, mutual trust between members of the organization” so that “the organization can control its knowledge creation (28-29).”

From our discussion, we can observe some traditional aspects of the entrepreneur. In a context with given knowledge, it is the job of the entrepreneur to reduce inefficiencies. This promotes the equilibrium result of traditional supply and demand analysis (Kirzner 1963). Not wholly unrelated, the entrepreneur brings new innovations to market. These represent an expansion of knowledge that we often refer to as technology in economics. Joseph Schumpeter (1942) referred to such innovation as “creative destruction”, noting its short-run disequilibrating effects. As Kirzner (1999) points out, what this entrepreneur has actually done is bring about a new equilibrium that is reached in the process of market competition for profits generated by the innovation. Finally we observe political entrepreneurship. While this sort of entrepreneurship can tend to be unproductive or destructive, especially in regard to state politics (Baumol 1990), within a firm a transformation of political orientation may be required to increase efficiencies. Changes may naturally arise when a firm is in crisis, though successful handling is never guaranteed. This certainly would be the case for implementation of the sorts of knowledge sharing management policies that Nonaka observes and suggests (1994, 28).

Wednesday, February 8, 2017

Entrepreneurship: rationality and human action

Within the context of the market, entrepreneurship consists in seeking monetary profit. In the broader context, entrepreneurship consists of seeking psychic profit. As we define action as consisting of an agent’s attempt to influence the future toward a state of the world he prefers. In acting humans attempt to mold the world to their liking. Action is inherently entrepreneurial.

Every actor is not equally skillful. Some are better than others at generating end states that they prefer. It is these men and women that we tend to think of as entrepreneurs. We often use the word leader in our society. Those of great fame tend to include market entrepreneurs and CEOs and politicians. Market entrepreneurs earn profit by organizing the production and sale of goods and services. These are positive sum transaction for all involved so long as no negative externalities are generated from their activity. Market entrepreneurship is inherently value creating when markets are subject to rule of law. Political entrepreneurship creates value for those players involved, but often generate negative externalities. Political systems that employ the use of force – i.e., the state – tend to engage in zero sum transactions. Revenue in politics arises from transfers that are enabled by the use of force. We call these taxes. If you fail to pay taxes, the political system will continue to inflict pain upon you in the form of imprisonment and further fines.

You may be surprised to learn that some market entrepreneurs have spearheaded one of the most successful genres of literature: the self-help book. Writers like Zig Ziglar and Dale Carnegie did not begin their career as professional writers and speakers. They learned the art of social organization by working in sales and rising through the ranks of their respective companies. Dale Carnegie went on to write the now famous How to Win Friends and Influence People and Zig Ziglar left behind a legacy having written books like See You at the Top and Selling 101. One author, Og Mandino, overcame great hardship and poor lifestyle. He had at one point in his sales career suffered from alcoholism and even considered suicide. But he became transformed from the reading of self-help books, development in his own faith, and the transformation of his mind. Og Mandino’s The Choice tells the story of a man who, supported by his family, chooses to be an author and abandon a successful career. He faces much hardship along the way, but persists to follow his desire. He eventually succeeds.

All of these works are permeated with optimism. They represent a different way of seeing the world. One does not simply live to survive. These authors believe that men and women are themselves authors of their own lives. They believe that humans embody a design suited for prosperity. These men evidence an instance of rationality that breeds success in the realization of one’s ends.

Defining rationality
When we speak of rationality, we mean that there is a logic that governs action. Rationality is lately a term of abuse. Some use the term to refer to action that they prefer. Irrational action, on the other hand, is action that one does not understand or simply disagree with. This framing is incorrect.

Rationality requires three things. Logical structure (a model), data, and ends. We will refer to the logical structure as a model or map. Science, for example, provides us models, but no end toward which these models should be used. When we speak of a positive science, such as economics, we mean to say that we are attempting to model the social world in an objective manner. It is possible, and often is the case, that the model guiding one’s decisions and actions is skewed by the ends of the actor. We often see this in the development of ideologies and other beliefs that arise as a convenient explanation of an individual or groups belief. Consider the recent outcry against executive action by the American left, which was largely silent when president Barack Obama employed the same means to implement policy.

In your day to day life, rationality need not be especially abstract. Your model of your mother or your brother does not need to be generalized to anyone else. If you do generalize, you more than likely are not conscious of such generalization. If you meet a man Robert and come to find that he reminds you of your brother, you probably do not identify that, in fact, you borrow a bit from the model of your brother in your interaction with him. In psychology, we see a reference to this with Jungian archetypes. (It is no coincidence that Jung was in the Viennese milieu. He used a form of categorical analysis that, while particular to his system, shares general features with that of Ludwig von Mises.) You need not treat these as ineffable, but as a child it is reasonable to think that you see the world in only two categories: mother and not mother. As you observe more data through experience, this model of the social world expands. You come to understand that you have a father and likely derive further social concepts from these to early archetypes. Those do not handle you with the love of the mother or the tenderness of the father are placed in a category of people who are not appreciated by you. You cry at their touch or voice.

It would hardly be accurate to see the wincing of a baby at the hands of an unknown woman as irrational. Given her model of the world, which is literally infantile, the baby acts rationally. As with all human action, the baby acts with the end of feeling comfort and to remove felt uneasiness. The baby’s response is to avoid something whose outcome she believes to be not beneficial to her. The baby responds to data that does not fit into the category of mother or father. The unfamiliar is regarded with discomfort and even fear.

Artificial intelligence and rationality
Self-help authors suggest a change in the perception of the reader is necessary. Dale Carnegie (1937) divides his book into four sections: “Fundamental Techniques of Handling People”, “Ways to Make People Like You”, “How to Win People to Your Way of Thinking”, and “How to Change People Without Giving Offense”. In each of these sections, there is embedded a belief that one can change the pattern of his or her actions. Robert Kiyosaki, author of Rich Dad, Poor Dad, presents to ways of viewing and interacting with the world which are personified by the two fathers in his story. These authors and others like them understand that personal transformation lies in a change in perspective. It requires a change in mindset, the interface through which one interacts with the world. Interaction with the world requires understanding of it (Dweck 2006; Simon 1996).

Most people do not appreciate that they do not interact directly with reality. The Viennese scholars in the late 18th and early 19th century referred to this as verstehen: interpretation. Scientists seek to create an objective model of the world (Hayek 1943; Hayek 1955). Scientific knowledge abstracts away from unnecessary features and observe only those elements that we believe to be impinge on the phenomena being studied. Human understanding is the knowledge of the acting agent, whether scientific or lay. Action is guided by the logic of one’s model of the world (Johnson-Laird 1980). We attempt to refine our understanding such that we may interact with an environment coherently (Gigerenzer 2008). The usefulness of one’s understanding is reflected by the success of action generated by that knowledge. Fitter knowledge will tend to allow acting men and women to achieve their ends that promote survival more efficiently (Hodgson and Knudsen 2010; Alchian 1950).

Knowledge is thus a means to action. Personal knowledge identifies aspects of the world as they relate to one’s place in it. A woman born in Harrisburg, Pennsylvania and remained there for the entirety of her life will likely have little reason to learn Tok Pisin, a language spoken in Papua New Guinea. If she is a receptionist dental office, she will probably lack the knowledge necessary to repair and maintain a Mercedes Benz S500. Unless one finds value in learning some subject for its own sake, a person’s knowledge will reflect the needs that arise in her life. Our lives are embedded in our models of and interactions with the world.

This embeddedness includes beliefs about one’s capabilities and ethical or moral valuations and obligations that constrain action (Granovetter 1985).  These are often bound up in a grand narrative whose feature reinforce these fundamental beliefs. In a similar manner, one's narrative includes beliefs about ability that also embed themselves in action. A woman who is tormented by self-doubt will be unable to act confidently. She tells herself stories that validate her belief that the world can in no way offer her the things that her heart desires. A man who is prideful will have a difficult time integrating new information that discounts his high self-evaluation into his knowledge. All action is guided by logic contained in the acting agent’s knowledge set. Over time this logic becomes ingrained in habits.

The structure of artificial intelligence can help inform our understanding of this aspect of human action. Artificial intelligence relies on classifier systems. These are programs that sense and evaluate an environment, using information present in it to classify or rank potential strategies and parameter values governing those strategies. Action guiding elements that receive the highest ranking are chosen by a classifier system. The classifier system represents one interface by which an acting agent interacts with its environment. It guides the choosing of a strategy which is itself an interface that enables a particular mode of action in the environment. In the same way, a user of a computer program can only interact with the program in ways enabled by the program itself. A basic word processor cannot be used as a calculator, neither can a calculator be used to compose an essay. One program lacks the categories and functions necessary to enable the features provided by the other. Agents with artificial intelligence can only interact with the environment in a manner that is enabled by their programming.[1] They require the ability to sense particular phenomena in their environment and the categories necessary to interpret this information. A lack of information from the environment or the perceptive framework required for behavior that conforms to context will inhibit agent functioning.

The structure implied by the narrative with which a person identifies governs her perception and guides her response to the environment. In economics, we postulate that agents act as to attain a state that she most prefers. She cannot do this directly. She requires structure in the form of a rule. You may think of this as a strategy.

We can begin to understand how rules affect our behavior by thinking about wardrobe choice in regards to the weather. In choosing what clothes to wear for the day, a person may follow the following set of rules concerning the expected high temperature (degrees Fahrenheit) for the day:
If expected high temperature ≥ 70: wear shirt with short sleeves
If expected high temperature < 70: wear shirt with long sleeves
If expected high temperature < 60: wear a sweater and shirt with long sleeves
If expected high temperature < 40: wear a coat, sweater, and shirt with long sleeves
Rules like these serve as guide rails for action. They make decisions making less burdensome for the choosing agent. If I follow these rules and the high tomorrow is 65, I will wear long sleeves. If it is 35, I will wear long sleeves, a sweater, and a coat. I choose to obey this rule set, an observer can surmise that feeling cold brings me substantial disutility. An observer may be able to surmise the rules followed by an agent on average by analyzing past agent action in light of conditions.

A person must choose a higher level rule that facilitates her choosing of a lower level rule. Just as a classifier system selects the rule governing action according to some ranking identified by the system, so too the human agent must choose higher level rules that guide the selection of lower level rules. Examples of such rules include moral and ethical systems, though not all rules are equally functional. One has no option but to select such a system or at least choose to accept the system that is provided her. Free will exists at this level of choosing. No rule system can itself do the ultimate choosing (Carroll 1895). One may choose to defer the ultimate choosing of action to a passion (Blackburn 1995). Such an embrace of a particular form of ends selection is itself a choice. Free will and the power for personal transformation that it enables exists most radically at this level. Action that results from the rule structure that manifests from this high level decision becomes embedded in habit over time. Thus our action evidences our beliefs. Our works evidence who we are to those who cannot know in detail what we believe.

[1] It is often the case that the results potentiated by a particular program are not fully knowable beforehand.

Rationality - A description of a system guided by logic. Such a system includes a model of elements believed to be significant to guiding action and a means to ranking potential action in light of the state of the environment as identified by the model. The system for ranking ends must itself be chosen.

Mental Model - The protypical model that acting men and women use to interpret and interact with their environment.

Embeddedness - A description of social capital where knowledge held in a system is contained within the relationships and interlocking mental models of agents. This knowledge is inseparable from interaction, and is thus embedded in the social system.

Tuesday, February 7, 2017

A brief theory of goods and prices

Economics is the study human action in light of a budget constraint. It observes action in terms of means and ends. The agent perceives her environment and is able to imagine how she may acquire some end. We assume that the agent values any end that she seeks to realize. Traditionally, this valuation reflects utility that the agent expects to receive. By hypothesizing that the agent measures value in terms of homogeneous units of utility, we have been able to employ the metaphor of calculus to understand rationality in the economic system. No such units exist in reality. Rather, the agent ranks ends in light of the magnitude of desire, which reflects the benefit that the agents expects to receive from the good in light of its cost. Monetary prices, however, reinforce the metaphor of an optimizing calculus as agents are forced to compare valuations of goods by allocating wealth in terms of monetary prices.

We observe action by agents who are attempting to realize states that they prefer more over those they prefer less. Those are state-goods. State-goods include goods that are discrete objects and functions. If I decide to join a friend for an early morning coffee, I have acted to attain a state-good. I forgo spending the morning in bed as well as the monetary cost of coffee and transportation.

All valuations occur in the present. If I act to attain a candy bar, the candy bar is a good as I attain it. I assume that I am be better off with the candy bar than without it. It is possible that the candy bar will be a link in a long chain of consumption that degrades my health, but in the moment of action, I choose the candy bar who utility from consumption is realized for me in the short term over good health that I would receive in the long term if I choose to abstain from these habits.

Goods can also be functions or, in other words, a service or a process. Some men will pay to talk to a woman on the phone who is a complete stranger simply to alleviate their loneliness. They have paid for a good that exists only at the time of consumption. Others pay significant amounts of money to play videogames and may even buy artifacts in the game that have no existence outside of the game. Others will pay for characters in the game that have been matured by another player. Still others, when able, will pay for a surrogate mother (Kuchar 2016). All of these are things that the consumer prefers over other options that they might otherwise choose.

Agent preferences for goods comprise an ordering. At any moment, the agent must choose one good over another. When he receives his pay for the week, he must choose which food to buy. Over the course of a year he knows that he must purchase some new clothes and determine which he shall purchase. He must choose a means of transportation to facilitate other actions. Ludwig von Mises argues that these choices evidence a preference ordering. Only action can evidence preferences. Ordering is itself a challenge. On a week to week basis, a typical preference may include food and energy. On a month to month basis, we may add housing to the list. On a yearly basis clothes and vehicle repairs. Those goods that are not typically purchased in a shorter period must be accounted for by savings or debt. It is in this sense that we think of an agent’s planned expenditures. They can only purchase goods for which they have the wealth necessary to acquire them.

Concepts from programming languages can inform our modeling of the agent. We may create an agent in a program who has a list of goods that he purchases every day. Another list of goods that he purchases every week. Another that he purchases every month and so on. The agent could systematically purchase certain goods at particular times during each cycle. Or perhaps there is a 1 in 30 chance, for example, that the agent buys a good on his monthly list on any given day. Any goods not purchased on a given day but purchased at a later point exist either in the form of savings or future income, that latter of which includes loans.

These economic goods are all subject to scarcity. That is, not everyone who wants to use them is able to use them. A standard example of a non-economic (free) good is air. While it is true that air is available to anyone who would like to take a breath, the quality of air will be priced into land values much as parking that is supposedly free is priced into the value of commercial real estate (Demsetz 1964). Air is free to anyone who is willing to suffer the cost of living without a claim to a warm bed, but for others, free goods become an attribute of value attached to the other goods for which they pay, as we observe in a theory of hedonic pricing.

Property, ownership, and prices
In order to deal with scarcity, some form of ownership must exist. An economic good require the assignment of right of use over it. An agent’s scope of action is delimited by her property rights. The extent of her property rights will determine her preferred course of action. How long can she expect to control a piece of property? Can she sell the property? What are legitimate uses of the property? Any economic system must define the possible space of terms of ownership if any order is to arise at all in the economic system. If they are not already known, they are discovered through a process of trial error in the legal system.

In absence of property rights allocated to an individual, the political structure governs the use of resources. In this case, ownership is nominally in the hands of the state or some other political apparatus and practically shared by bureaucrats and managers. The value they can extract from this ownership is a rent. A man who manages farmland for the state may allocate use to an agent who will later reciprocate the manager’s actions. Systems that disallow for personal ownership make planning for use of property more difficult. One cannot be certain whether he will have access to property and revenues generated from it in year or decade’s time. Rather, personal relationships centered around power become the dominant mode of economic planning for individuals. These relationships are not subject to contract, but rather the continuance of goodwill which is itself dependent upon incentives embedded in the economic system. They fall under the category of reciprocal relationships, which economists so often disregard in their analysis but which are integral to any description of institutions.

Under a system of private property, agents are able to make better use of their resources. Owners of property are allowed to collect revenue from some use or sale of the property. This alienability of property rights is fundamental in the formation of expectations, which include market prices that reflect the value of the land according to its estimation of its most profitable use. If the owner is allowed to sell the land, buyers will only be willing to buy the land if it is offered at a price that is lower than the value they expect to derive from its purchase. Competition among buyers will tend to move prices more quickly toward the value given existing economic conditions. If I am a landowner who is not generating the highest possible value from the use of my property, I have incentive to sell it for the value it will fetch in the market. If I so value the land that I am willing to offer it for sale, I value the proceeds more greatly than I value maintaining control over the particular asset.

Under a system of alienable property rights and competition, prices play a fundamental role in communicating to users and potential users the scarcity of a good in light of the cost of the good’s supply. By cost we refer to the value of the opportunity cost of the good’s use. If the current owner of a good derives value from the good that is higher than the monetary value of the next best use, we expect that the current owner will not relinquish control. It is possible that the current use actually generates less revenue than the next most valuable use. The owner could be made to have greater material wealth as valued by the market – other men and women. If he fails to sell it at this price, then he values his ownership and use of it more than the extra revenue he would receive by the property’s sale.

Prices operate in a fractal manner. A person may be willing to pay a certain price for a good. That person offers some amount and is successful in purchasing the good. If the seller notices that buyers are usually willing to pay prices that are relatively higher than he had been selling, he may increase his asking price. If he has correctly sensed that consumers are willing to pay a higher price, he will earn higher revenues for his sale. If consumers are not willing to pay a higher price, then the entrepreneur will come to regret his decision. Assuming that he has not raised price due to an increase in costs, he earns a profit. This increase in price will encourage the producer to produce more than he had before at the lower price. He and others like him will provide a greater quantity of the product to market, producing to the extent that the producers expect will be profitable.
Supply and Demand
Perhaps the most recognized tool of economists, supply and demand curves express core principles that underlie economic analysis. A demand curve can represent the quantities demanded for a particular good at different prices from an individual, a group, or for all consumers. Likewise, a supply curve can represent that combinations of prices and the quantity of a good produced at the price from a single firm, a group of firms, or all firms in the market. The point at which the supply and demand curves cross indicates the equilibrium price and quantities for the good provided by the market in light of consumer demand and supply constraints.
Both supply and demand curves are a manifestation of marginal analysis. We assume that all action is a result of decision-making at the margin. We do not assume that, for each individual, the value attributed to consumption or possession of one unit of a good is equal to the value attributed to consumption or possession of an additional unit of that good. Here we assume that value of one unit is not dependent upon possession of another unit, as in the case of chess pieces. A set of chess pieces that is missing one piece, say the black rook, gains aesthetic and functional value by the possession of that final piece. In most cases, value attributed to the possession of an additional unit of a good is lower than the value attributed to possession of the previous unit.
Consider the decision to purchase a thumb drive to transfer files between to computers. If you have 4 gigabytes of data to transfer, we can assume that you will positively value a 16 gigabyte thumb drive. If all files fit on this drive, however, we can expect that a second drive of the same size will be less valued by you. Likewise, consider that you can only attain thumb drives that are one gigabyte in size. We can expect that you will load files that you most value – i.e., that you most need – on the first thumb drive. As you attain additional drives, you will transfer files that you value less or, in other words, that you less urgently need.
Action and Value
In economics, we assume that acting men and women act in the way that they believe will bring them the most value. This holds for Mother Theresa, who valued a life of servitude, as much as it does for Wall Street’s Gordon Gekko. Economics says nothing about what a person values or should value. It accepts that people value some goods and states of the world more than others and that their actions are an attempt at realizing value according to their beliefs and preferences.
When this assumption is attributed to analysis that employs supply and demand curves, we express this as utility maximization. Economic agents allocate their budgets toward the consumption and possession of goods that they believe will yield them the greatest satisfaction per currency unit spent. It also happens that this assumption allows economists to employ calculus to estimate demand curves from past observations.

Supply and Demand
Perhaps the most recognized tool of economists, supply and demand curves express core principles that underlie economic analysis. A demand curve can represent the quantities demanded for a particular good at different prices from an individual, a group, or for all consumers. Likewise, a supply curve can represent that combinations of prices and the quantity of a good produced at the price from a single firm, a group of firms, or all firms in the market. The point at which the supply and demand curves cross indicates the equilibrium price and quantities for the good provided by the market in light of consumer demand and supply constraints.

Both supply and demand curves are a manifestation of marginal analysis. We assume that all action is a result of decision-making at the margin. We do not assume that, for each individual, the value attributed to consumption or possession of one unit of a good is equal to the value attributed to consumption or possession of an additional unit of that good. Here we assume that value of one unit is not dependent upon possession of another unit, as in the case of chess pieces. A set of chess pieces that is missing one piece, say the black rook, gains aesthetic and functional value by the possession of that final piece. In most cases, value attributed to the possession of an additional unit of a good is lower than the value attributed to possession of the previous unit.

Consider the decision to purchase a thumb drive to transfer files between to computers. If you have 4 gigabytes of data to transfer, we can assume that you will positively value a 16 gigabyte thumb drive. If all files fit on this drive, however, we can expect that a second drive of the same size will be less valued by you. Likewise, consider that you can only attain thumb drives that are one gigabyte in size. We can expect that you will load files that you most value – i.e., that you most need – on the first thumb drive. As you attain additional drives, you will transfer files that you value less or, in other words, that you less urgently need.
Figure 1

Action and Value
In economics, we assume that acting men and women act in the way that they believe will bring them the most value. This holds for Mother Theresa, who valued a life of servitude, as much as it does for Wall Street’s Gordon Gekko. Economics says nothing about what a person values or should value. It accepts that people value some goods and states of the world more than others and that their actions are an attempt at realizing value according to their beliefs and preferences.
When this assumption is attributed to analysis that employs supply and demand curves, we express this as utility maximization. Economic agents allocate their budgets toward the consumption and possession of goods that they believe will yield them the greatest satisfaction per currency unit spent. It also happens that this assumption allows economists to employ calculus to estimate demand curves from past observations.

Demand curves are constructed from the decisions of agents to spend wealth. When someone chooses to purchase a particular good, he or she is choosing that good at the cost of all other goods that he or she could buy. This is represented in Figure 1 by the point (QA*, WA*).
Where
QA = Quantity Purchased of Good AWA = Wealth Remaining After Purchase of Good A
Notice that this person could choose to spend the total budget on the good A, on which case that person will receive the quantity M/PA. Conversely, this person can choose not to spend any of his or her wealth on this good, in which case, wealth will remain in the form of money or be spent on other goods.


The agent making this purchase believes that the gain in value, or utility, per dollar spent is maximized in comparison to other purchases he or she could make. This goes on such that the agent continues to purchase goods so long as the utility gained from that purchase exceeds the value gained from purchasing other goods as well as the utility gained from holding a unit wealth in the form of money. In Figure 1, the agent has remaining $(M – PA Q*A). In other words, the money not spent on good A can be spent on other goods.

If it is true that individuals purchase goods that provide them the greatest amount of value per dollar spent, then it is also true that consumers will respond to changes in prices. The quantity demanded of a good is inversely correlated with the price of the good. If, for example, the price of the toothpaste that I typically use to brush my teeth doubles, then it I will likely consider using another toothpaste. If the price of gas doubles, I may consider spending less time traveling or choose more often to ride my bicycle or walk when I visit places nearby. Demand curves reflect this attribute of preferences as they are downward sloping on a plane where the horizontal axis is the quantity demanded and the vertical axis is the price. For a market, they represent the sum of agent preferences for the good in question. The points of a demand curve represent the different quantities of a good that will be purchased across different
                                   
Figure 2

Understanding prices with supply and demand curves
A price may rise for two reasons and only two reasons. Either, there has been an increase in demand for the product, as in the case of the discussion above. Price may also increase if the cost of supply increases. This may occur if the price of an input for the goods production increases.

A rise in price of a good systematically leads to a decrease in the quantity consumed. If the government implements a 5% tax on oil revenues in effort to reduce consumption of oil, it will likely be successful in the goal as less oil will be produced in the area subject to the tax. Similarly, if the price of oils falls as a result of the introduction of cost reducing technology, more oil will be consumed.

To say that there has been an increase in demand (Figure 3) is to say that there is an increase in the consumer’s willingness to pay for a product. Likewise, a drop in demand is a lowering of a consumer’s willingness to pay. As sentiment of consumers tend to move together, on average, we often refer to an increase in demand in the market for the good. When smart phones first became available, not everybody was interested in owning one. The value to early users was likely novelty and status, in addition to convenience. But as the use of this technology spread, those who lacked the ability to be more accessible found advantage in using this technology to communicate with friends, family, and coworkers. Utility gained from the use of these phones increased due to a network effect, and demand thus increased (Figure 4).

In the case of supply, we refer to movements in the price that suppliers are willing to accept for sale of a good. In a competitive market, this price tends toward the cost of provision, as the lowest cost suppliers will be able to undercut less efficient providers of a good. Competition in an environment with relatively free flow of information will tend to remove suppliers who fail to adopt cost saving technologies adopted by the most innovative competitors. Producers who decided that they will only provide landline phones when cell phones first came into use are likely struggling if they have managed to survive the last decade. The cost of supply may fall, and therefor the supply increase (Figure 4), due to an improvement of conditions. For example, if an area occupied by corn farmers becomes more rainy, farmers will be able to produce more corn at the same cost.


Figure 3

Figure 4


To better understand supply and demand, we employ supply and demand curves. We say that demand curves slope downward and supply curves slope upward. As the price of a good falls relative to other goods, consumers are willing to purchase more of the good. We explain this phenomenon in two ways. Agents always have a limited budget constraint. A decision to purchase one good is necessarily a decision to go without another good. Therefore, as the price of a good rises, our agent’s real income falls. Of course it is possible that a single agent will always buy a certain good if the price is not too high. At some point, the quantity the agent is capable of purchasing may fall to zero if the price rises too high. Acting in light of a budget constraint, agents must choose to purchases goods that they believe will provide more value to them, as opposed to less. This is a necessary condition for the downward sloping demand curve. The agent will eventually reach a point of consumption where an increase in consumption of the desired good will be accompanied by relatively less utility with each unit consumed. This is the principle of decreasing marginal utility. As an agent’s budget constraint shrinks, or in other words as the relative price expenditure increases, those goods that provide relatively less utility per dollar spent will be forgone for those that provide more.

Supply curves are upward sloping. This is derived from the fundamental concepts of opportunity cost and action. Tautologically, action attempts to create the greatest value for the agent. Agents take action that will bring him to a state of being that he prefers over other possible states. This means that, given the agent’s wealth, he will attempt to trade things that are less valuable for those that are more valuable. Likewise, production of goods come at some cost. The highest cost producers tend to produce at the market price. If consumer demand for a good increases, then the price consumers are willing to pay increases. Higher cost suppliers can therefore enter the market profitably.

Figure 5

Figure 6

We assume that supply and demand are independent of one another, but it is possible to show their interaction via the price mechanism. That is, it is possible that demand affects supply over time. Much modern technology has shown this pattern. Smartphones, which were relatively expensive when they were first introduced have proliferated in industry and can be purchased for relatively cheap, so long as the phone desired is not the newest and fastest model available (Figure 6). We see a general description of this phenomenon with Moore’s law: the speed of processors tends to double every one to two years (Figure 7).[1] Thus, we increasing processor speeds and a continual fall in the price of processing power and memory for a computer. Producers respond to technological demand from business who are willing to pay a high price for the fastest and best functioning computers. These businesses must remain competitive or else be removed from the market through bankruptcy. The same principle holds for tech savvy consumers who find value in using the latest technology. Demand from these agents push up the price of new technology so as to make innovation profitable and thus incentivize reduction in the cost for a unit of memory or processing power.


Figure 7

The Law of One Price
Movement toward an equilibrium price in a market is implied by the principle of human action. Humans act to move the world toward a state they prefer. They do this subject to a budget constraint, which represents the resource at their disposal. From this we surmise that if there are gains from trade potentiated by discrepancies between prices of some like goods, these discrepancies will be offset so long as they are profitable. We call the act of exploiting gains that arise from price discrepancies, arbitrage.

If the price of an ounce of gold in England is $1500 and the price of an ounce of gold the U.S. is $1505, there exist an opportunity to profit by buying gold from England and selling it in the United States. If the cost of buying an ounce of gold in the U.S. and selling it in England is less than five dollars, we expect that the final price in either country will lie somewhere between $1500 and $1505. If the cost of buying and selling and ounce of gold is zero dollars, then we expect that both countries will reach exactly the same price.

A similar process occurs when shares are bought on an exchange, however, a layer of complexity is added. Imagine that instead of the price of an ounce of gold, we observe the price of a share of gold worth one ounce from a gold exchange trade fund (ETF) is worth $1505 in the U.S. and that a share in Britain is worth $1500. The shares from Britain cannot be bought in the United States, however, investors will shift demand instead of moving supply. Those invested in the ETF in the U.S. will sell shares and can reinvest them in Britain. Demand for shares of the U.S. based ETF falls and demand for the ETF based in Britain rises.

There are cases where the law of one price appears to be violated, however, this is always due either to transaction costs or subjective valuations of acquiring a good. Consider two apartments that are identical in every way except location. If the apartment in New York is worth four times the value of the price in Omaha, it is not because the law of one price has been violated. The goods are commonly referred to as being non-tradable. One good cannot be used for the same purpose of another. Not only are transportation costs especially high for real estate, the conditions that exist in one area, including scarcity, cannot be transported to another area.

There also exists discrepancies between observed prices. A gas station on one street corner may charge a higher price than one on the opposite corner and still not lose customers. Often, this may occur because the price discrepancy is small and drivers are willing to pay this cost in order to stay in the comfortable zone delineated by their habits. But if the price of gas at one station increases high enough, its profits will shrink as drivers choose to purchase gas at the station across the street.

The profit mechanism, driven by the desire of human agents to improve the state of the world that they inherit – most patently when the choice is between having more or having less of something for the same cost – drives the market process. This drive when in operation in a competitive environment at least approximately subject to the rule of law promotes the convergence of expectations, allowing for a high level of coordination where plans of economic actors come to fit together. This is Adam Smith’s invisible hand and what Daniel Klein refers to as concatenate coordination.



Good – An object or state toward which an agent attributes positive value.

Scarcity – A state in which an agent must choose between ends due to there being limited quantities of goods desired.

Opportunity cost – The next best use of a good or action. In a market, agents are able to measure the value of an opportunity cost in terms of a currency unity.

Economic good – A good that can that is subject to scarcity and that can be bought and sold. Economic goods are sold for a positive price.

Price – That which is given up by an agent in exchange for something that he believes is more valuable.

Monetary prices – Prices denominated in a currency. An agent must give up an amount of currency equal to the monetary price in order to attain a good desired.

Human action – Action by a man or woman is always aimed at replacing an incumbent future state with an expected state that the agent values more highly.

Property rights – Property rights serve to legitimate ownership of an object and delineate the use that is allowed by such ownership. Rights over a property may be divided, such as the case where ownership of a piece of land is maintained by one owner and the rights to minerals beneath the property are sold to another.

Preference ordering – At any given time, an agent prefers to spend his wealth on some goods as compared to others. Those goods that an agent chooses to purchase during a finite span of time are represent those goods toward which he attributes the greatest value.

Budget constraint – An agent has only a finite amount of wealth. The value of this wealth, whether it exists in currency or assets that may be sold, represents the agent’s budget constraint.

Demand – An agent’s willingness (and ability) to pay for some good represents his demand for the good. If the agent experiences diminishing marginal utility from consumption of the good, the price he is willing to pay for each addition unit of the good falls.

Supply – Production of a good always implies opportunity cost. The value of opportunity cost tends to increase with the quantity of the good produced once efficiency increases from mass production have been exhausted.

Endogenous – As being generated within a model. If an increase in demand for a good raises its price such that it promotes new investment in cost reducing technology, the increase in supply that results is an endogenous increase in supply.

Law of one price – The observation that the price of like goods tend toward equality in light of transaction costs.

Expectations – Predictions of agents concerning the future. Expectations is a broad category that includes both price expectations – predictions of future price – along with plans and strategies that agents use to adapt to a changing environment, and institutions whose logic help coordinate agent interaction and plan execution.

Invisible hand – The observed tendency for competitive markets to make efficient use of resources and promote the dovetailing of plans acted on by disparate actors.



[1] Moore's law refers to an observation made by Intel co-founder Gordon Moore in 1965. He noticed that the number of transistors per square inch on integrated circuits had doubled every year since their invention. Moore's law predicts that this trend will continue into the foreseeable future (From  Wikipedia).