Upward-Sloping Short-run Aggregate Supply

Today we add short-run aggregate supply (SRAS) to the analysis. The short-run aggregate supply curve is tricky to justify theoretically. Given an increase in the money supply, the SRAS convey that total output increases as a result of increase in aggregate demand and a delay in price adjustments. It is convenient to think of this in terms of nominal income and then consider the behavior of the individual variables.

Imagine that there is an increase in the money stock of 5%. Given the log-derivative of the equation of exchange, this looks like

%∆M + %∆V = %∆P + %∆y

Rewrite as:

%∆M + %∆V = %∆(Py)

For now, let’s assume that portfolio demand for money is constant. Now,

%5 + %0 = %∆(Py)
%∆(Py) = %5

Within a static model, we know that in the long-run, the price level will absorb the entirety of the change, and that y remains unchanged. This is known as the classical dichotomy. Often rendered, “Reals affect reals, and nominal affect nominal.” In the real world, however, we see that nominal changes have real effects. A more realistic rendition states, when the economic activity is in something close to an equilibrium condition, changes in nominal aggregates do not lead to long-lasting changes in a given measure of aggregate output. It is possible that at first a change in y comprises some portion of the change in the nominal income. In the long run, y returns to its original level as prices come to fully reflect the increase in the money stock.

A thought experiment is enough to convey the nature of short-run effects. Imagine that, over night, Hume’s money fairy has increased everyone’s money balances by exactly double. If, at the moment this occurred, not before, all agents became aware of this doubling, there would be no effect on the allocation and employment of resources. Now, let’s imagine that our agents only become aware of this slowly. Some agents are able to spend the money before prices rise. Of course some suppliers have become aware of this change, but certainly all of them have not. At least some of those who recognize their increase in cash balances will make purchasers from those suppliers who have not changed the price. These suppliers may even believe that there has been an increase in demand and will sell more than they would have if that had realized that they suffer from “money illusion.” This leads to a temporary increase in output that will last as long as suppliers do not increase their prices. Eventually, competition and a need for solvency forces them to act in accordance with economic reality. Prices rise and output falls back to its long-run level.

As prices rise, there is no reason to expect that all prices move in the same direction at the same time. It is possible that a substantial portion of the increase in money is used to purchase only one or a few types of goods. These markets receiving the new money will increase prices more quickly than those that do not. For example, the doubling of the money stock might increase the price of luxury goods by 3 or 4 times since those who discover the new money early on feel richer. Relative prices shift as money enters the economy through the purchase of specific goods.

As prices rise, not only are relative prices distorted, but so also is the function of profit. Profits appear to be augmented by the price increases, but again, this is only due to "money illusion." Irving Fisher’s observation is of help to us:

“I remember particularly a long talk with one very intelligent German woman who kept a shop in the outskirts of Berlin. She gave all kinds of trivial reasons for the high prices. . . When I talked with her the inflation had gone on until the mark had depreciated by more than ninety-eight per cent, so that it was only a fiftieth of its original value (that is, the price level had risen about fifty fold), and yet she had not been aware of what had really happened. Fearing to be though a profiteer, she said: ‘That shirt I sold you will cost me just as much to replace as I am charging you.” Before I could ask her why, then, she sold it at so low a price, she continued: “But I have made a profit on that shirt because I bought it for less.

 She had made no profit; she had made a [economic] loss. She thought she had made a profit only because she was deceived by the ‘Money Illusion’. . She had kept her accounts in what was in reality a fluctuating unit, the market. In terms of this changing unit her accounts did indeed show a profit; but if she had translated her accounts into dollars, they would have shown a large loss. . . ” (392)

I am an economist by training. I don’t think in terms of price levels in my day to day life. I notice that the prices of goods change from time to time. Some of the change may be due to an increase in the money stock. Some may be from changes in demand due to preferences or to supply shocks. A change in price tells us nothing about why a price has changed. Uneven adjustment of prices changes the nature of monetary exchange. Humans think in terms of observed nominal prices. Losses are easier to stomach when they are written on a balance sheet as a nominal gain, as Fisher’s story shows. Even if all agents came to know of the increase in the money stock beforehand, their preparations cannot prevent the realization of errors in prediction of prices of specific goods that are inevitable for the vast majority of agents. Agents with expectations of an increase in the money stock cannot necessarily prevent a temporary increase in AD. Distortion of the profit and loss mechanism promotes this outcome.

Now that we've worked through this thought experiment, we are ready to consider what happens by considering a graph of aggregate demand, short-run aggregate supply, and long-run aggregate supply. We consider an increase in aggregate demand.

Two effects are working here. The short run effect, which temporarily elevates y, and the long-run effect, which dominates the short-run effect having P absorb the total change in the money stock. It is important that we do not interpret long-run and short-run as representing specific time span. These are categories that describe types of change. The long-run is the state to which the model eventually converges. Long-run changes always swamp short-run changes. It is possible that long-run effects set in very quickly so that short-run changes are hardly observed. Or short-run changes may last for an exceptionally long period of time. There is no measurement of time that can consistently define the long-run and short-run. 

Dynamics of Aggregate Demand

Money may be thought of as the life blood of any economy. Possession of money by an agent empowers that agent to coordinate resources and even other agents. It is a mistake to look at money only as one good among money. This perspective may aid analysis of changes in the value of money and its allocation, but they only partly capture money’s influence. Money is the universal numeraire. It is the measuring rod that aids economic calculation. In every exchange that occurs in a monetary economy, money is one side of transaction – the other side being the good or service offered in exchange for money. Given this feature, a dichotomy arises between the demand side and the supply side of the economy. The demand side is represented by the money that is available to be used for the purchase of goods and services. The supply side is comprised of the flow of existing goods over some time period and the stocks already on hand. To avoid shortages or surpluses, sellers of goods must adjust prices to accommodate changes in demand for goods. Markets also experience fluctuations in aggregate demand as 1) the money stock fluctuates and 2) general demand to hold money changes. That is, the tendency of agents to collectively decrease or increase consumption over a period is reflected by fluctuations in total expenditures of all agents.

Those of you who are familiar with macroeconomics or have been engaging the previous posts in thorough dialectic will, I hope, see what this implies for macroeconomic analysis. The equation of exchange helps us to identify the aggregate demand and aggregate supply. Recall that MV = Py. Total expenditures on final goods and services is equal to the nominal value total income. For the exercise, let us assume that the economy is static so as to avoid analytical problems that arise from innovation. For now, we will assume that prices adjust to accommodate changes in the supply of and demand for money. Of course, the store owner would likely never imagine that he is accommodating these changes. She instead adjusts price of the good based on changes in available stocks of the good itself as well as changes in the price inputs. She also accounts for expected changes in demand for the good at the given price. Remember, as Hayek (1945) argues, that suppliers need not know the source of a price change. They only need to correctly interpret an appropriate cue or cues that helps them adjust prices to prevailing conditions. In this early analysis, we shall make the grandiose assumption that prices adjust instantaneously. In the future, we shall consider situations where the given array of prices produce excess supplies of goods. For now, we will consider the nature of changes in the aggregate demand curve both at the instance of the change and the equilibrium outcome results.

               

Now we have appropriately identified our objects of analysis and the objects that comprise them, we may move forward in employing the aggregate variable M, V, P, and y. Aggregate demand and aggregate supply are both described in P-y space. As mentioned above, the aggregate demand curve is defined by total outlays, MV. The curve intersects the long-run aggregate supply (LRAS) curve at some price level comprising the equilibrium state. The value y* at this point is the value of real income in the long-run. At this level, the economy is said to be at full employment.

                

Figure 1

The aggregate demand curve falls as a result of an decrease in either the money stock, M, or an increase in demand for money (equivalently a fall in velocity). In Figure 1, the AD curve falls, but the reason is not indicated. For the sake of analysis, let us assume that this change was either entirely the result of a fall in the money stock or an increase in demand, but not a combination of both. Possible changes in the composition of total expenditures, MV, that yield this result are shown below in Figures 2 and 3.

Figure 2

                    

Figure 3

The effect of changes in total expenditures is dependent upon the nature of subsequent price changes. If adjustment of prices is instantaneous, than there will be no change in y. Iif agents perfectly predict changes in prices given a change in the money stock or a change in demand for money, there will be no temporary change in output. This is the long run effect of changes in these variables, given that complications do not arise within the capital structure. (Say a wave of bankruptcies results from an increased rate of insolvency. Contracts are typically set in nominal, not real terms. In that case, nominal changes can, therefore have real effects.)

If prices do not instantly adjust, then we are left with an excess demand for money and an excess supply of goods. The excesses perfectly offset one another. The value of the excess demand for money [Figure 4] is equivalent to the value of the excess supply of goods [Figure 5]. This can only be alleviated by an adjustment in the price level – i.e., adjustment of all prices to cohere with the new allocation of money. The process of the opposite adjustment works in reverse. An increase in AD brought about by a fall in demand for money or an increase in the money stock will create excess demand for goods and an excess supply of money. As with the previous example, this will eventually be offset by changes in prices. (You  may want to refer back to this paragraph in the coming discussion of Say’s Principle.)

 Figure 4

Figure 5

A final warning. The process of adjustment in a real economy is not as smooth as aggregate analysis might suggest. Remember that this is a tool for conceptualizing aggregate changes in a monetary economy. A change in the price level tells us little about changes in relative prices (price ratios). These will be considered in the section on monetary policy under the heading of the non-neutrality of money.

Intuitive Sums: Making the Equation of Exchange Easy to Interpret

Today I’m going to work some fast math magic. Yesterday I reviewed the equation of exchange. Working with the products can be somewhat confusing. So, briefly, I will show the reader how to transform the equation of exchange into (approximate) sums of percent changes. The process is straight forward.

1. Begin with the equation in its basic form

MV = Py

2. Log both sides

ln(MV) = ln(Py)

3. Convert into sums of logs

ln(M) + ln(V) = ln(P) + ln(y)

4. Take the first derivative of both sides

(dM/M) + (dV/V) = (dP/P) + (dy/y)

5. The result is approximately the sum of percent changes

%∆M + %∆V = %∆P + %∆y

6. Rearrange so that desired variable is on the left hand side of the equation. I’ll leave this last step to you.

Notice that this is useful for setting up a regression. If you have data for the 3 variables, you can estimate the fourth. It should be kept it mind that measures of velocity tend to be measures of this sort. If I were to attempt to measure changes in velocity, the form of the equation would be,

%∆V = %∆P + %∆y - %∆M.

Notice that this is similar to the log version

ln(V) = ln(P) + ln(y) – ln(M).

A regression with the log measures will estimate the log of velocity while the equation using the derivative of the logs will estimate percent changes.

One last trick: P and y can be merged, and rightly so. P is a variable that is estimated. Better sometimes to use the aggregate, Y instead.

MV = Py 

MV = Y 

V = Y/M 

ln(V) = ln(Y) – ln(M) 

(dV/V) = (dY/Y) - (dm/M) 

%∆V = %∆Y - %∆M

Enjoy!

The Equation of Exchange, Its Versions, and Its Elements

Where does the value of money derive from? There is a common misconception that money must have some intrinsic value. A common question I hear from students is: “The dollar is backed by gold, right?” While the earliest moneys came into existence by virtue of the use value of the commodity traded, this is not the case in the world of modern finance.

As you know if you have been reading this series, money essentially arose by accident. When some agent comes in possession of a commodity that she plans only to exchange, rather than consume, the agent increases her demand for that good. The value gained from this type of increase in demand represents the value of the object as a medium of exchange. Thus, money has two sources of value: value derived from use and from exchange. As a commodity used as a medium of exchange gains value, producers are encouraged to increase production and new producers of the good are drawn by the opportunity of profit. Notice that endogeneity of the money stock (for example see this) – the tendency for the quantity of money to adjust to changes in demand for it – falls out of this example as a property that derives from the price system. More on this later. (This will also be important in coming posts when I review the automatic operation of a prototypical gold standard.) 

Like any good, money, at a given moment and over extended time horizons, is potentially offered for sale by agents at some array of prices. Ex post we observe the prices associated with particular transactions. Likewise, at a given moment, agents collectively demand some quantity of goods at a given array of prices. Ex post, these observed prices are equivalently the prices for supplied quantities (for simplicity let’s assume that the supplier of the good incurs all costs that might otherwise be spread over a network of producers).

Given the above construction, we can consider what might happen given changes in the preferences and agent knowledge concerning the available stock of money, its quantity demanded, and factors of supply. One additional tool for analysis is required: the equation of exchange (often identified as the quantity equation which is a derivative of the equation of exchange). The equation of exchange is an accounting identity that equates the quantity of money demanded with that supplied. The stock of money and its average velocity of circulation (an unfortunate term meaning the number of times the average currency unit is spent in a given time period) is identical to the quantity of goods purchased times their transaction prices. The rendition has thus far built upon microfoundations. In the modern formulation, we reduce the series of prices and goods to aggregate variables. Thus:

MV = Py

where

M = money stock

V = velocity

P = price level

y = real income

These variables tell us nothing of the composition of the economic system. Rather, it conveys an important truth about the supply of money (MV) and the demand for money (Py). As John Stuart Mill expressed in his Principles of Political Economy,

The supply of money, then, is the quantity of it which people are wanting to lay out; that is, all the money they have in their possession, except what they are hoarding, or at least keeping by them as reserve for future contingencies. The supply of money, in short, is all the money in circulation at the time.

The demand for money, again, consists of all the goods offered for sale. Every seller of goods is a buyer of money, and the goods he brings with him constitute his demand. The demand for money differs from the demand for other things in this, that it is limited only by the means of the purchaser.

As those demanding dollars and those supplying dollars successfully exchange and satisfy their preferences for dollars and goods, each market for money tends toward an equilibrium. This in no way suggests that the economy moves smoothly from equilibrium to equilibrium as agent actions and preferences are not independent of one another. The actions of every agent changes the distribution and prices of scarce goods. All markets, including markets for money, experience endogenous turbulence.

Types of Demand for Money 

It is necessary to more closely examine elements contained within the equation of exchange in terms of the demand for and supply of money. There are two types of demand for money contained within the identity. These are transactions demand and portfolio demand. MV represents the money stock that is available for exchange and that Py represents the demand for money by sellers of goods and services. Demand, however, can be broken down further. On the right hand side there is nominal income which is equivalently transactions demand. All goods sold must be exchanged for money. The money exchanged comprises transactions demand.

Portfolio demand for money is a different type of demand for money that consists of the demand to hold money. This demand is represented indirectly by the velocity, or rapidity, of circulation of money. Remember that the available supply of money is MV. The total money stock multiplied by the average number of times a given currency unit is spent represents the available money stock for a given time period. Money that is spent multiple times in a given period influences prices across that period. Money that is withheld from circulation by agents fails to positively impact the prices of any good, assuming that there is no expectation of expenditure later. The equation of exchange can be rewritten to include this demand for money on the right hand side of the identity.

MV = Py

M = (Py)/V

Let k = 1/V

M = Pyk

This formulation, known as the Cambridge cash-balance version, shows that the total money stock is equal to the product of transactions demand (Py) and demand to hold money on reserve (k).

The Quantity Theory

The quantity theory is a particular rendition of the equation of exchange where velocity – the inverse of portfolio demand – is assumed constant and where real income is thought not to be affected in the long run by changes in the money stock.  It is stated as

This is a long run definition that shows that an increase in the money stock, all else equal, will lead to an increase in prices generally.

Endogenous Money

With the quantity theory, causation is thought to work from the left to the right side of the equation, but this is not always the case. Imagine that there occurs a general increase in demand to hold money. The immediate effect may be for prices to fall, but this does not occur instantaneously. Remember that an increase in demand for money tends to increase its price, also known as purchasing power. Under a commodity money standard, a rise in the price of money will encourage production of that money. This is easily conceptualized with the Cambridge cash-balance interpretation. Recall

               M = Pyk

If k – portfolio demand for money – increases, then M may also increase, owing to an increase in money’s price, in order to offset this effect.

Endogenous Credit

An increase in demand for money does not have to be offset by an increase in the base. Thus far, I have not differentiated between different types of money. Money consists not only of base money, but of higher level moneys known is fiduciary moneys. (Fiduciary meaning the value depends upon faith in the promise to repay). These moneys are linked to base moneys typically by a promise of repayment. Into the first half of the 20^th century, this type of currency was best embodied by deposit slips which served as a claim to base money and which were exchanged as money. Then, as now, the money deposited at the bank was lent to agents who demand money in the present and promise repayment in the future. Their demand for money now is constrained by the price of money in the future known as the interest rate. If agents generally increase their demand to hold money, other agents who need money for transactions in the immediate future can borrow and thereby increase the quantity of money presently available. Of course, they must be willing to repay this debt and the interest accrued during the life the loan. As we have not yet covered banking, it will suffice for you to remember that credit adjusts according to changes in demand for money. This will be discussed in greater detail in later posts.

The Emergence of the State Monopoly over Money

Just as it is possible to construct a theory of the emergence of money based on principles of agent preference and action, so too is it possible to build a theory of the state monopoly of money with such principles.

Both history and theory converge on the conclusion that money was by no means a creation of the state. Money arose as agents confronted difficulties associated with barter. Instead of bartering directly, agents began to accumulate some goods for the purpose of indirect exchange. Depending on time and place these goods have come to include shells, oats, cows, and the more commonly recognized silver and gold. As agents converged upon common goods for exchange, the commodities began to act as moneys: goods that act as 1) a medium of exchange, 2) a store of value, 3) a unit of account, and 4) a standard of deferred payment. The emergence of money allows for the beginning of specialization that is characteristic of a human economy. A more robust civilization can then be supported. It is at this point in our story where we left off last post.

As society converged to gold and silver for facilitating commerce, this presented an opportunity for the ruling class and those aspiring to comprise it. It is an obvious observation that an increase in money, all else equal, is equivalent to an increase in wealth, and therefore, power. The role of money minting, then, commands an appreciable amount of power. As in any market, this power increases with the establishment and enforcement of monopoly privilege.

There is no a priori reason that we should expect a monopoly on money to occur. In his essay, “An Evolutionary Theory of the State Monopoly over Money", David Glasner argues.

For the production of a good to be a natural monopoly, the technology must exhibit economies of scale that ensure that the average cost of production is always lower if one for produces the entire output of an industry than if two or more firms with access to the identical technology divide the output. But even if the state were the lowest-cost producer of money, it would not necessarily enjoy the economies of scale required for the existence of a natural monopoly.

Printing of the seal of the sovereign on money is in no way evidence that the state was required for monetary stability. The seal of the sovereign may have given “traders more confidence in the weight and fineness of coins.” The sovereign, however, was “seeking not to improve the monetary system but only to exploit profit opportunity implicit in this premium”. A theory of the state monopoly is mistaken if it seeks to justify the monopoly by an argument based on the public good (not to be confused with the category known as public goods). While such an argument is not excluded from comprising part of the explanation, the core of the explanation must also consider the motives of agents close to power and involved in coining.

Glasner offers one clear explanation for the emergence of state monopoly: defense. He is not so naïve as to try to describe the process of this emergence as involving high-minded principles that guided the sovereign to attempt to stabilize and improve the monetary system. Competition for power is fierce. Any leader, elected or unelected, faces competition from numerous agents who would prefer to have the power for themselves and their own allies. One regime is always at risk of being displaced by another. A weapon that an agent or team of agents might potentially use is their influence over the money stock.

Minting a large quantity of debased coins might enable a private mint owner to finance an attempt to overthrow an incumbent sovereign. To be sure, such a debasement would violate the mint owner’s promises about the content of the coins he was issuing. But upon becoming the sovereign, the owner could avoid any legal liability by annulling his legal obligation to those he had defrauded.

A mint-master who sought to overthrow the existing regime could inhibit money’s role as a unit of account by debauching it while increasing one’s wealth in the process.  Given this threat, monopolization of the production of money is not only an opportunity for a sovereign to profit, but also to keep political competitors at bay. A sovereign might well feel justified, then, in establishing not only a monopoly over the mint, but also establishing legal tender monopoly.

This sort of problem appears to be reflected in the writing of Nicolas Copernicus. In his “On the Minting of Money”, he argues,

It would be advantageous therefore for there to be only one common mint for all Prussia, in which every type of money would be stamped on one side with the insignia of the lands of Prussia: they should have a crown at the top, so that the superiority of the kingdom would be recognized. On the obverse, the insignia of the duke of Prussia could be seen under the crown above it.

A charitable interpretation suggests that Copernicus was worried about mint-masters in Prussia threatened the stability of the Prussian empire by minting debauched currency. If this was the case, the defense argument may have been at the forefront of Copernicus’ mind. It is also possible that Copernicus had in mind that Prussian leadership would consider his suggestions. Whether or not a mint-master would successfully destabilize the ruling regime before going out of business is another question entirely. Hume seems to have had something similar in mind, though his worry concerned the extension of credit by private banks, as opposed to dishonest coinage. Not only did he suggest that a single bank should regulate the credit stock – presumably the Bank of England – he even suggested that it is the job of the sovereign to ensure its modest increase.

The good policy of the magistrate consists only in keeping it, if possible, still increasing; because, by that means, he keeps alive a spirit of an industry in the nation and increases the stock of labour, in which consists all real power and riches.

Again, this seems to be a case of an economist acting as a policy wonk. Perhaps Hume should have looked north to the hills of Scotland to notice the relative stability of its freebanking regime. (The end of Hume’s life coincides with the early years of relative stability under the free banking regime in Scotland.) Economic stability promotes political stability. Hume’s emphasis on internal stability and progress fits well with Glasner's theory.

               Defense is important both to the internal politic and in foreign affairs. While the former likely served as the primary impulse for state monopoly, the latter was served by it.  Even in a regime that typically promotes policies supporting sound money, major wars tend inevitably to devalue the currency. When a nation enters into war, the monetary system becomes a tool by which resource can be coordinated toward the war effort. Glasner mentions that this was a recurring theme in the ancient world. We also witness this in modern and early modern wars. Whether one considers the depreciation of the continental during the American Revolution or that of the British pound during the Napoleonic wars or the widespread suspension of the gold standard during World War I, modern governments have a habit of funding wartime expenditures via monetary inflation much like their counterparts in antiquity (Hawtrey 1947, 69, 92-105; Webster).

Whatever the cause of a fall in a currency's value and whether or not that fall in value is justified by circumstance – such as war – the effect of manipulation of the monetary unit alters the composition of the money stock in circulation. When devalued money of a particular nominal value circulate alongside coins of the same denomination but of different, more highly valued composition, there arises a an increase in the costs of barter. Agents engaged in exchange must consider the value of a coin’s metallic content. For example, imagine that we have two coins that weigh 1 oz and have different compositions. Coin A is 4 parts silver and 1 part gold (or in other words, 4/5 of an oz silver and 1/5 oz gold). Coin B is 4 parts gold, 1 part silver. Assuming that gold is worth more than silver, coin B is worth more than coin A. Since it is convenient to trade with coins of the same denomination, agents will continue to trade with coins of this 1 oz denomination, but they will tend to remove the coins with more gold from circulation. These coins serve as a store of value – defense against inflation – while the cheaper money is employed as a medium of exchange. Of course, coin A might also serve as a store of value, but the chance of continued devaluation makes ownership of the coin A more attractive for this purpose. This outcome is typified by Gresham’s law.

Having considered the emergence of a state monopoly over money, the analysis has been primarily concerned with premodern and early modern institutions. This leaves us to consider whether or not a state monopoly over the production of money - at least base money - is justified. Glasner closes by suggesting that, in the least, the state can no longer claim that a needs of national defense justifies for the monopoly as monetary policy has come to be a tool for the promotion of "high employment and economic growth." Thus, we have an explanation of the emergence of a state monopoly over money rather than an explanation of its continuance in the modern era.

The Emergence and Functions of Money

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. This occurs when an agent senses a profit opportunity. 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 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, lets 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. These prices fluctuate according to changes in the quantity demanded at a given price or, if we are not in the long run, a given array of prices (in the subjective sense of the word). Likewise, prices fluctuate as quantities available at given prices fluctuate. 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. Though we shall continue to improve the model, it does, at this point, contain a core capable of extensive analysis of the market order.

Next post: Money and the State

Types of Entrepreneurial Action and Overcoming Difficulty: Trade Facilitation, Innovation, and Political Entrepreneurship

The manner in which we economists conceptualize entrepreneurship sometimes does a disservice to the complexity and difficulty of entrepreneurial action. Kirzner describes the entrepreneur as being alert to profit opportunities. Kirzner’s entrepreneur brings into existence trades (pure pareto improvements) that would have otherwise not occurred. Schumpeter's entrepreneur brings innovation to markets, with the potential of upsetting entire industries. Baumol’s entrepreneur is not so kind-hearted. She seeks to improve her lot with little regard to some ethical postulate about her nature. She engages in rent-seeking, securing revenue, not by bringing innovation to a market or experimenting with arrangements within the production structure, but by guiding the power of the state to benefit one’s own company or harm competition; all this without regard for the costs borne by taxpayers. What do all these renditions have in common with each other? These brief summaries overlook that the job performed by entrepreneurs is not only filled with uncertainty, but is also difficult. In what follows, I argue that each type of entrepreneurs can use tacit knowledge to overcome difficulty (a phrase I borrow from Scott Page) and secure gain for oneself.

Page compares difficulty with uncertainty. He writes,

Thus, uncertainty refers to the absence of information about some relevant variable or what some call the state of the world – tomorrow’s weather, to give one example, is uncertain. Difficulty refers to problems that have many interacting variables [emphasis mine]. Developing a workable form of fusion is difficult as is designing an office building or writing a piece of legislation. Difficult problems have many possible solutions and no obvious best one a priori. When faced with a difficult problem, most problem solvers prove incapable of finding the optimum. They must rely on perspectives and heuristics.

Page describes a difficult problem as containing “many interacting variables”, or phrased slightly differently, many interacting elements. These elements may be particular agents or offices of authority or prices or communication lines and so on. Imagine the type of work required by Baumol’s entrepreneur. In order for congress to pass a piece of legislation that benefits a particular firm or set of firms, those firms may need to donate to multiple congressman, launch a campaign that attempts to attract media support, and even work together with other organization, no matter how diverse, in order to build enough support to pass the bill. Any faltering along the way may lead to a loss of a critical ally or some other missed opportunity that prevents all the elements required to accomplish the task from assuming the state necessary for the bill to pass. While these sorts of events might happen by accident, the organization required to take advantage of such an opportunity is probably not formed accidentally. Individual opportunities may arise by surprise, but these opportunities likely require good organization and alertness in order for them to bring an entrepreneur any benefit.

I believe a less technical example will prove to be more salient. Several years ago, Moneyball, a movie starring Brad Pitt and Jonah Hill, showed the story of Billy Beane, a manager of the struggling Oakland Athletics, attempting to find a strategy that might allow the Athletics to at least make the playoffs despite a tight budget. In one of the more intense scenes, Billy Beane yells at his colleagues, “If we try to play like the Yankees in here, we will lose to the Yankees out there!” The previous season, the Athletics had made the playoffs but lost in the first round. To add to this pain, the Oakland Athletics lost some of its best players, including Jason Giambi, after that season. Desperate for a solution, Beane brings in a young economics graduate, played by Jonah Hill, whom he hired out from the Cleveland Indians. The two agree that players need to be chosen by their on-base percentage. The trick was simple. Build a team that has a relatively high on-base percentage given the price tag of each player. Hill’s character describes this team as being discriminated against within the industry like “an island of misfit toys”. These players were undervalued.

The story does not stop there. Beane continues to face problems. The team’s manager, Art Howe, who is played by Phillip Seymour Hoffman, refused to arrange the players as requested by Beane. At first, a frustrated Beane argues with Howe. But he eventually looks for opportunity within the fray. He finds it, trading away apparent party-boy Jeremy Giambi (Jason’s brother) along with a few other players. It just so happens that these players were integral to Howe’s lineup. He has little choice but to play the lineup arranged by Beane in the positions that Beane assigned them. Beane continues to find opportunity throughout the movie. Early on, he bought an aged-but-not-out David Justice. Frustrated that he is part of Beane’s experiment, he does not hide his sourness. Justice was one of the few players on the team with a sense of maturity, but he did not use that maturity to guide the younger, less confident players. Just as Beane’s strategy is implemented, he approaches Justice and encourages him to act as a leader to a team that so badly needs leadership on the field. At the end of the season, Beane’s strategy gained legitimacy as the Athletics won 20 consecutive games.

Although I’m not sure which parts of Lewis’s story and the cinematic adaptation are more true and which are less, I do know that Beane acts as a prototypical entrepreneur throughout the film. In order to help the Athletics earn a playoff bid, he had to alter the state of a handful of elements on the team in such a manner as to increase the overall efficiency, as measured by dollars paid per win during the regular season. Here we have both a case of Hayek’s man on the spot and Schumpeter’s innovator. As a man on the spot, Beane know the ins and outs of the game. He knows the network that he operates within and holds the attitude necessary to operate within that network. He is not surprised at the resistance that he faces from the old guard, so he preps for it. Only experience can build this kind of knowledge and ability. Beane manipulates tacit information to his advantage throughout the movie. Beane also engages in Schumpeterian creative-destruction. After Beane’s team succeeded as what appears to be the result of his adoption of econometric techniques – 20 consecutive wins seems like good evidence of this, though one cannot honestly claim that econometrics was both necessary and sufficient to accomplish this. In any case, Beane was successful enough to convince the Boston Redsox of the strategy. The Sox won the world series only a couple years later (after Beane turned down a handsome offer from them)!

So we have an ontology of entrepreneurial action within the context of markets. Within an equilibrium framework, entrepreneurs find and enable trades that would never be realized otherwise. Important for promoting the health of the system, entrepreneurs constantly transform the marketplace through innovation. More rudimentarily, they even transform agents’ perceptions of the world. Who could have imagined the existence and our dependence on computers over a century ago? Or imagined that Uber could pick me up within 5-10 minutes of my opening the app? Yet now, computers are part of our everyday lives. Computer programs even serve as metaphors of reality. A handy example of this is agent-based computational modeling. Innovation reverberates throughout the market, and almost equivalently, throughout our lives. Sometimes, opportunities for the entrepreneur may lie outside of the market order. (Speaking of Uber, who has been paying attention to the way that the company has “gamed the [regulatory] system,” to use Brian Arthur’s phrase, both through rent-seeking and outright disregard for cumbersome local and state regulations? A new wave of political entrepreneurship may be upon us.) And often, entrepreneurs face complex situations that are difficult to conceptualize and that are ultimately traversed by means of trial and error.

Being an entrepreneur ain't easy, but beneath every difficult problem there is profit to be earned.

The Role of the Entrepreneur: Coordination and Innovation

Entrepreneurs guide production according to the needs of consumers. Remember that a good is a type of object whose definition is a subjective. The final consumer must expect that the good will improve his or her position enough that he or she actually purchases the good. The entrepreneur’s role is to provide that good to the consumer. Note the inherent difficulty in this role. Consumer demand is not inherently stable. Preferences are subject to fluctuations. Consumers can also be swayed by a competing products. Recently, producers of phones employing Android platforms have been facing steep competition from Apple. Many have switched to the iPhone6, and, as a result, Apple has reaped record profits. And let’s not forget about competitors that faded away long ago. Remember when Nokia was dominating the market for cell phones, only to have its gains swept away by smart phone providers? In serving consumer demands, entrepreneurs engage in a dynamic process of competition. Most entrepreneurs eventually fail!

Entrepreneurs are thus an integral part of a system of decentralized planning. In his economic treatise, The Theory of Social Economy, Gustav Cassel recognized this process of decentralized planning.

The difficulty of the problem lies precisely in the fact that the constantly varying demands of consumers, which cannot be determined in advance with any degree of certainty, must be satisfied, despite incessant changes in the methods and conditions of production. This work is actually done – naturally not perfectly – by a number of independent entrepreneurs, each of whom, on the whole, looks merely to his own interest.

This solution of the problem is possible because, whenever a want that can be paid for is left unsatisfied, or is not completely satisfied, or satisfied only at an abnormally high price – every time, that is, the problem of the economic direction of social production is not satisfactorily solved – an entrepreneur is encouraged by the prospect of earning a special profit to make a better provision for the want in question, and the productive process is thus steadily improved. The entrepreneurs intervenes, not only where something is to be done for the immediate satisfaction of consumers’ wants, but everywhere where the productive process, somewhere among the thousands of its component processes, exhibits a gap which leaves room for his enterprise. In this way, all these partial processes are united into a single productive process, embracing the entire satisfaction of wants in the exchange economy. (95)

In the process of providing goods, the entrepreneur is responsible for transforming and building portions of the structure of production. Imagine that entrepreneur as having the responsibility of ensuring that the nodes under his control are profitable. Profit signals to the entrepreneur that he improving the lot of consumers at the end of his supply chain. Loss suggests that the entrepreneur is failing. If the entrepreneur fails for too long, he will incur losses that force him to withdraw from the market.

While the primary job of the entrepreneur might be generally described as earning a profit, his role can be described more thoroughly. The job of the entrepreneur can be divided up into several categories. In one early formulation, Joseph Schumpeter (1928) describes the entrepreneur as innovator.

Successful innovation is, as said before, a task sui generis. It is a feat not of intellect, but of will. It is a special case of the social phenomenon of leadership. Its difficulty consisting in the resistances and uncertainties incident to doing what has not been done before, it is accessible for, and appeals to, only a distinct type which is rare. Whilst differences in aptitude for the routine work of ‘static’ management only results in differences of success in doing what every one does, differences in this particular aptitude result in only some being able to do this particular thing at all. To overcome these difficulties incident to change of practice is the function characteristic of the entrepreneur.

Although Schumpeter stresses the discontinuous nature of innovation and economic growth, innovation can be of any magnitude. Small improvements in existing technology surely counts as innovation just as much as more substantial changes – say the invention of the lightbulb or telephone or steam engine. With each innovation, improvements are made over exist technologies. This provides the entrepreneur an opportunity to earn a profit. For this to occur, consumers must also expect that the improvement will benefit them. Otherwise, the supposed improvement is not improvement at all. Thus, a role exists for advertising to bring in the consumer as a participant in the trial and error process.

Successful innovation allows the innovator to overtake old competitors. When Henry Ford increased the efficiency of production of motor vehicles, the days of the horse and buggy quickly came to an end. With the massive adoption of cell phones, land line connections have become much less important for consumers. Remember the rapid ascent and decline of VCRs of the course of a couple decades? (Maybe you don’t!) No firm can use a single invention to rule the market for an extended period of time without confronting competition.

Competition is key to the market process. It is inherent in any form of decentralized planning where agents and firms operate with legal equality. The world is filled with opportunities to improve the welfare of consumers. These opportunities are discovered, whether out of intention or by accident, by entrepreneurs and provided to the market by the will of the entrepreneur. In the next post, I will consider the role of tacit information, discovery, and difficulty in the process of entrepreneurial competition.