Simple Economics
L. David Roper
E-mail: roperld@vt.edu

Consider a society composed of two human beings, or two families, or two separate groups of humans that are both highly homogeneous and cohesive. For simplicity the two components will be referred to as two "individuals." Call them Abe and Zeb.

Suppose that initially Abe and Zeb settle with equal resources in an isolated valley; that is, they come in with equal goods, they divide the land equally according to its apparent potential, and they have no interactions with the outside world. Consider various economic (Definition: Of or pertaining to the development and management of the material wealth of a government or community.) scenarios that might develop as time advances.

Scenario I. Complete Economic Independence

Assume that the land is wooded and very fertile, that there is appropriate precipitation and other weather phenomena, and no destructive natural events occur. Then Abe and Zeb may each obtain his own needs without any dependence on the other. That is, beyond the initial division of the resources there is no economic interaction between Abe and Zeb.

The continuance of complete independence for a long period of time seems unlikely because of the gregarious nature of humans and the inter-relations of the physical resources owned by the two individuals. Of course, complete independence simply means that the two are completely isolated from each other, as well as from the outside world.

Scenario II. Minimum Economic Inter-dependence

Although Abe and Zeb may start out essentially independent, it seems likely that Abe may become skilled at producing some necessary or desirable item A using his natural resources and Zeb may develop a skill for producing a different, but equally necessary or desirable, item Z.

They may then agree to trade or barter (Definition: To trade by exchange of goods or services without use of money.) these items, rather than each produce both. Then they are confronted with the basic economic problem of exchange rate: How many (= a) A's produced by Abe will be exchanged for how many (= z) Z's produced by Zeb?

There are two basic considerations in arriving at the exchange rate:

• Human resources: What fraction (H_A for A and H_Z for Z) of an average human lifetime is required to produce the item? (Of course, one individual may contend that the other is slow or lazy.)
• Non-human or natural resources: What fraction (N_A for A and N_Z for Z) of the relevant natural resources are required to produce the item? This is difficult to estimate, because more than one resource may be involved and one usually does not know all possible future limitations on the resources. A better, but also difficult measure to determine, is how much energy in work and mass is required to produce the resource. For now we remain vague about how to measure these quantities.

Assume that the four fractions described above can be determined and agreed upon by both individuals.

Now Abe and Zeb are confronted with the classic economic dilemma: How important is human working time relative to the natural resources used in producing an item. Since Abe and Zeb are dealing with their own working time, assume that they weight their working time equally with their natural resources. Then the exchange rate is:

For example, suppose that A requires one year of Abe's time and 0.01 of his relevant natural resources; whereas Z requires six months of Zeb's time and 0.001 of his relevant natural resources. Then, for a 70-year average lifetime:

Thus, according to this calculation, Zeb trades three of his Z's for one of Abe's A's.

Although A and Z are items necessary or highly desirable for human existence, they may not be required at the same time or in the ratio of three to one at a particular time. For this and/or other reasons it may be desirable for Abe and Zeb to establish some kind of credit or currency system, and perhaps a banking system.

Credit System:

Instead of exchanging one A for three Z's (or whatever the rate is) for every transaction, Abe and Zeb may agree to deliver their products whenever they are requested or are produced, with both parties keeping a record of all items transferred. Then over a period of a year, or some other agreed upon convenient time interval, the total number of exchanged items must be in the required exchange ratio. Thus, at any time one individual may owe some items to the other. For one item from each individual this record keeping is quite simple; but for many items from each individual the record keeping can be quite complex and require a large amount of time.

Currency System:

To obviate the necessity of keeping extensive records, Abe and Zeb may decide to manufacture together an item whose only purpose is to serve as a convenient medium of exchange. Such a currency, called C, must be manufactured by a process (e.g., by mining and minting or printing) under strict surveilance by both parties. The first distribution of the currency and any subsequent distribution of new currency supplies, are equal to Abe and Zeb, since they manufacture them in common. The amount of C in circulation at any time is determined by the amount needed to make the transactions with some surplus.

The exchange rate between the currency and any other item is established in the same way as is the exchange rate between two items as described above. That is, the price of item A (the number of pieces of currency or money C) is:

and the price of item Z is:

where H_C is the fraction of a human lifetime required to produce a piece of currency and N_C is the fraction of the relevant common natural resources required to produce a piece of currency.

For the specific example given above assume that H_C = 2 days and N_C = 0.00001; then:

and

(A check on the correctness of this calculation is that the ratio is about 3.)

Now, instead of directly exchanging items A and Z or keeping elaborate records for credit, Abe and Zeb can "pay" for the items with the proper number of pieces of currency C as they receive the items. For the example given each A item costs 275 C's and each Z item costs 92 C's.

It is convenient to define a prefix symbol to represent the basic unit of currency C; use the $ symbol. Then for the example given: P_A=$275 and P_Z=$92.

Currency System Dangers

There are several dangers that exist when a currency is introduced:

• Possibility of Counterfeit: Either Abe or Zeb may surreptitiously discover a way to make the currency item using less time or natural resources than the way originally agreed upon. Then it would advantage the discoverer to make some of the currency item without telling the other individual.
• Excessive currency surplus (inflation) is tempting. Such a surplus makes it easy for one individual to accumulate all he needs of the item produced by the other individual and then rest, instead of producing the items needed by the other individual.