How is a pencil created? This question was posited by Leonard Read in his popular story, “I, Pencil”. A pencil is a relatively simple product – relatively meaning, “in comparison to other products.” Still, it would be difficult for any one person to oversee the entire process of producing a pencil. Where does the wood for the pencil come from? How is it processed? How do the lumberjacks acquire sustenance? Where does the graphite lead come from? How is it processed? Who makes the lacquer? Where does the rubber for the eraser come from? Who brings all of these elements together? While it may seem like an obvious process, the problem of creating a pencil is a foray into the profound world of economic complexity.
How might we conceive of complexity in the economy? Economist Bryan Arthur describes the complexity paradigm as an accounting of continual emergence in an economy as plans of agents are constantly upset and readjusted (2013). Compare this to the equilibrium paradigm where agents have static preferences, only interact through price and quantity vectors, and do not affect one another even in the process of altering one’s own array of commodity holdings. The latter view is nonsense. It is clear that, if I acquire a particular good and other agents desire that good, that they cannot have the same good. With fungible – essentially identical – goods, this is not so obvious. Instead, consider a house that is for sale. If I and another person both desire the house, we will both have to guess at the bid price that will secure the house. One of us will earn claim to the house with a high bid, the other will not. In a world of scarcity, agents constantly face this sort of problem.
The problem does not stop with wealth allocation. If this was the case, perhaps the economy could be “solved” by computer programs that can emulate human preferences as Oscar Lange had hoped, though I doubt that this solution is workable. Beyond the problem of allocation is the abstraction that is necessary for individuals to engage in trade. What is necessary? Property rights. A common medium of exchange (money). Legal and accounting systems. Communication between parties. Can you think of any more? What do all of these institutions have in common? Before a trade can occur, individuals must develop the expectation that a trade can occur. Why should I, party A, expect that party B will want to trade with me, or that they even can? There is no reason to expect this a priori, but somehow, humans successfully engage in trades every day. What enables this? We must consider how institutions develop.
If I were to drive on the left side of the road in Fairfax, VA, I might receive more than a few obtuse looks from oncoming drivers. I will probably wreck my vehicle. In the United States, drivers have developed a habit of driving on the right side of the road, a habit that has been ingrained to the point of becoming law. In the same way, if I attempted to make purchases in Chinese yuan rather than American dollars, most vendors would likely turn away my business. Why? While dollars are legal tender within the United States, dollars were originally accepted as currency because gold and silver were commonly accepted media of exchange. Dollars (the word is actually derived from the German Thaler) are simply a measure of a particular amount of gold (~1/20 of an ounce). The common measure, formally adopted in the constitution, was consistent with the practices and expectations of the day. Ever since, Americans have used dollars to engage in commerce. So far, agents in the U.S. have continued to successfully integrate the exchange of dollars into their expectations. I could go on with examples, but I presume the reader understands the general argument: successful interaction between agents requires coordination that is only possible with a sufficiently high level of mutually compatible expectations. While some types of expectations help guide agents toward mutually beneficial interactions, other expectations are constantly upset. We think of upset expectations as "loss" that occurs within a system of profit and loss.
This brings us back to the question, how is a pencil created? How is it that loggers are fed and have access to coffee? Where do their saws come from? Where does the lacquer come from? Who makes the strips of metal that hold the eraser and connect it to the pencil? In the most basic sense, prices help coordinate this activity. Each agent having a finite budget must choose what he will and will not consume. He must plan accordingly so that his flow of income at least offsets expenditures. Agents all follow some form of this rule, and must change their approach if the rule is violated. Otherwise, they will go bankrupt.
We can imagine firms as forming a network that is the structure of production. Each node in the network – structure of production – employs are particular dollar value of resources. In order to be maintained, the structure of production must contain nodes whose revenues exceed their expenditures. This picture can be nuanced further by discounting revenue with respect the time period that resources are held. While this is not necessary in the short-run, the long-run tendency will be for the structure of production to lose any nodes/firms that are not at least earning the average (market) rate of return. This implicitly accounts for the cost of holding an asset. So we have a simple rule that organizes production without a single overseer. TR => TC. Firms do not have the privilege of attempting to guarantee that MR => MC except in discrete periods where they reevaluate their actions at the end of each period. A firm must choose a strategy for production and reevaluate at some later date (Alchian and Demsetz, 1972). At the end of each period, a firm can continue employing its previous strategy, revise its plans, or exit the pool of competing firms. We can extend this logic to labor as well. A laborer will compare the costs incurred for work with the revenue earned from working. If she can earn a greater wage elsewhere, she has incentive to change positions, though the change in position is not guaranteed for any individual agent.
In short, common expectations that facilitate agent interaction provide a medium by which production and exchange can occur. With common expectations regarding interactions sufficiently realized, profit and loss guide agents in the system. Those who have foresight will quickly adjust to changing agent preferences, technologies, and flows of revenue and capital in order to increase the likelihood of earning a profit. Those who don't will likely incur economic losses. The production of the pencil follows this general process. The firm that processes the timber, like the firm that creates rubber erasers or that produces yellow paint, will continue to produce as long as revenues remain sufficiently high. As long as entrepreneurs find a way to profit from each step of production, they will, in piecemeal fashion, successfully coordinate the resources and labor necessary to produce the final good that is a pencil.