Simple Way to Explain How Economy Works

I read this example from one of the economy book that I think it is the best example to explain how economy works as in general. The economy itself is very complex because it involves many people. What if I simplify the world to only 2 people with only 2 goods? Then, it makes this complex world way easier to be understood.

Classic Economy is Win-Win (1+1=2)

Assuming there are only 2 people in this world – farmer and rancher. Of course if farmer can only produce potatoes and rancher can only produce meat, it is obviously they can exchange their goods for the benefits each others. When they start exchanging, this is called trading. They start trading for the purpose of mutual benefit - this is called WIN-WIN.

Modern Economy is Synergy (1+1 >=3)

Let’s make this a little bit complicated that farmer and rancher can produce both meat and potatoes. Even though farmer specialty is to produce potatoes, Rancher can somehow still produce more meat and potatoes than the farmer.

Let’s look at the table below to understand the capability of these 2 guys can produce meat and potatoes in 8 hours:

	Meat	Potatoes	Comment
Farmer	8 oz	32 oz	Farmer’s capability to produce meat and potatoes in 8 hours.
Rancher	24 oz	48 oz	Rancher’s capability to produce meat and potatoes in 8 hours.

In order to enjoy both meat and potatoes:

• Farmer takes 4 hours to produce 4 ounces (i.e 8 oz /2) of meat and another 4 hours to produce 16 (i.e. 32 oz / 2) ounces of potatoes
• Rancher takes 4 hours to produce 12 ounces (i.e 24 oz /2)of meat and another 4 hours to produce 24 ounces (i.e 48 oz /2)of potatoes

As you can see, Rancher produces more meat and more potatoes than farmer. Now the question is:

• Should the rancher continue to trade or exchange goods with farmer?

Obviously no, right? However, Rancher thinks of a way to benefit to both of them to enjoy more meat and more potatoes. How does that possible? Let’s look at the conversation below:

Rancher: Hey farmer! Why you do something that you’re not good at?

Farmer: I want to enjoy the meat as well, I have to.

Rancher: I have an idea for both of us to enjoy more meat and more potatoes than we are producing now.

Farmer: Are you kidding? Don’t bluff me…

Rancher: No bluffing… listen carefully. Why don’t you 100% focus on producing potatoes and you exchange the potatoes with my meat?

Farmer: You must be insane! I got to work. Don’t talk non-sense to me anymore.

Rancher: Wait wait… If you’re doing full time producing potatoes, you can get 32 ounces of potatoes right? If you give me 15 of those 32 ounces, I’ll give you 5 ounces of meat in return. So now, you have 17 (i.e. 32 – 15) ounces of potatoes and 5 ounces. See? Now you enjoy 1 extra ounce of potatoes and 1 extra ounce of meat? Amazing, isn’t it?

Farmer: That’s sounds great. Why the hell you want to do that? If I enjoy more, then you must be enjoying less.

Rancher: No, not really. I enjoy MORE as well. See, I spend 6 hours to produce 18 (i.e. 24 oz / 8 hours X 6 hours) ounce of meat and spend 2 hours to produce 12 (i.e. 48 oz / 8 hours X 2 hours) ounces of potatoes. I exchange 5 ounces of meat with 32 ounces of potatoes that you have. So now I have 13 (i.e. 18 – 5) ounces of meat and 27 (i.e. 12 oz + 15 oz) ounces of potatoes. You see? I get extra 1 ounce of meat and extra 3 ounce of potatoes.

Farmer: Wow! This is so cool! But how does that work? I’m confused.

Rancher: That is MAGIC! :D

Summary of the Conversation

Perhaps you’re also confused with the conversation. Let’s look the gain from trade table below to understand the confusion:

Without Trading Gain (Farmer & Rancher work independently)

	Meat	Potatoes	Comment
Farmer	4 oz	16 oz	Farmer splits the 4 hours to produce 4 oz of meat and another 4 hours to produce 16 oz of potatoes.
Rancher	12 oz	24 oz	Rancher splits the 4 hours to produce 12 oz of meat and another 4 hours to produce 24 oz of potatoes.

With Trading Gain (Farmer & Rancher Start Trading)

	Meat	Gain from Trade	Potatoes	Gain from Trade	Comment
Farmer	5 oz	+ 1 oz	17 oz (32 – 15)	+ 1 oz	Farmer 100% focus to produce 32 oz of potatoes and exchange 15 oz of potatoes with 5 oz of meat.
Rancher	13 oz (18 – 5)	+ 1 oz	27 oz (12 + 15)	+ 3 oz	Rancher spends 6 hours to produce 18 oz of meat and spends 2 hours to produce 12 oz of potatoes.

Conclusion

Economy is everything about producing goods or services, exchanging goods or services or simply called trading.

• Classic economy is trading with the win-win benefits.
• Modern economy is trading with the achieving synergy in both parties.

In synergy, 1+1 >= 3 which seems to be impossible but it is proven possible with the example above. No trick, it is real! Amazing isn’t it? Imagine if the trading now is involving more than just simply 2 person, can you see how complex the Economy is? Can you see why no one can predict the economy?

P/S: As you can see, the very original reason we trade is for synergy or at least win-win? Now, what is your reason to trade? You just want to Win! But, are you winning?

By the way, you may also interested to read the Simple Way to Explain Subprime Crisis.