Lets imagine for instance that we’re the first human beings on earth and for the sake of imagination, I’m going to expand the number of people beyond Adam and Eve. Say there were 1000 of us dropped off on earth and we were its only inhabitants…You still with me? Okay, 1000 of us dropped off randomly in 50 different locales, with each locale having different assets and different numbers of people. By assets, I mean some have rice in abundance, and some have gold in abundance; Some are land locked while some are on the banks of great rivers; Some have crude in the ground while some have nothing but pure and unadulterated dirt beneath; Further still, in some locales, there are horses while in others, there are no horses…just elephants….Some have 20 people and some have 75 people…Okay, you get the picture. So there are 1000 people scattered across 50 different locales, with each locale having different assets.
Naturally, these 1000 people would move to ascertain some sort of control over the assets in their locales and it’s safe to assume that some would be more successful than others. Now imagine for a second that in a certain locale there is only one inhabitant named Joe. In this locale, Joe has an abundance of gold, oil, mountains and cactus. Imagine further that the soil in this locale is not good enough to grow anything worth eating. In fact, on a random visit to the locale across the pond, Joe discovered that it had wonderful soil, great agriculture, and a tiny amount of gold. The only issue with that locale was that there were few animals. Also, he found the people there quite mean and unwelcoming. He tried to introduce himself to a young lady and she looked at him like he was spawned from a pig. He had heard about another locale where animals were as plentiful as the people, and the people nice, but the problem was that it was a bit far. In a word, Joe has issues….He needs food and likely the arable land that makes the growing of food possible, but his locale is barren. The ground is hard and appears cursed. Yes, there is a lot of gold in the caves, but this does him no good half-dead from starvation.
On that random visit to the locale across the pond, he found that the people there were excited about the little gold that they had. In fact, those of them that had been able to corner what little gold was available were treated with much more dignity than those that hadn’t. The possession of gold in this locale was the key to status and esteem. In that moment, he caught an idea….”Why don’t I take some of the gold in my mountains and exchange it for some land…okay, maybe food. Who needs land anyway? I need food right now. Besides, I do not want to live among these people.” He decided this was the right thing to do, so he went back, took some gold and traveled back to the locale across the pond. He then proceeded to offer someone some gold for some food.
Sweet! I’m confident that the first commercial transaction this world ever knew was like the one described above. Around the world, sundry elementary school teachers refer to this as “trade by barter” and I dare say, they are correct. This is the only form of commercial exchange possible in the absence of legal tender (currency). Let us go back to Joe for a bit….Some of you might be wondering just how much gold Joe should exchange for food. It’s a great question and it leads me to one of my favorite principles of economics: The Law of Supply and Demand. I like to think that everything is governed by supply and demand. Some disagree with this notion, but they should write their own columns. Have you ever wondered how much the clothes you are wearing are worth? Not how much you bought them, but how much they are worth now? The answer is quite simple. They are worth as much as the market is willing to pay for them. Who or where is the market? Why, finding the answer to that is what makes great business people. There is a market for the shirt on your back, but first, you have to find it and then you have to determine if the price they are willing to pay is as much as the utility you derive from keeping ownership of it.
People in finance and economics often refer to an item’s “intrinsic value”- an oft bastardized term that I dislike using. I dislike the term because it creates an impression that Joe’s gold or your shirt, for that matter, has value in and of itself; or that there is some value hidden inside the item below which its price could not cross. I tend to disagree. Nothing has value when it is apart from a market. Markets determine value and they do so by supply and demand. When Joe goes to the locale across the pond, he and whoever he decides to trade with will settle on a certain amount of gold for a certain amount of food. How would Joe know if he settles on the right price? Well, the answer depends on what others elsewhere are willing to pay for his gold and how much gold is worth in the future.
In general, prices of an item rise when there is an increasing demand for the item and they fall when demand is decreasing. Inversely and generally speaking, prices fall when there is increasing supply, and they rise when there is decreasing supply. If all the people in the locale across the pond hear that Joe has gold to sell, I would expect that they would rush at Joe, and Joe would in turn start commanding a higher and higher portion of food for his gold. What happens if Joe remains oblivious to the fact that there are others in the locale who are willing to pay for his gold? Well, it’s safe to say that he would keep selling gold to the individual he first sold it to, and he would derive lower and lower portions of food for his gold…all others things being equal. In later columns, I will delve into supply and demand a bit more.
To be continued….we’ll pick up from where we left off