Tuesday, July 21, 2009

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.

21 Comments:

rssmatters said...

You make it easier to understand, but it is only an hypothetical example.

What happen if the potatoes farmers sell is rotten? Rancher might say bad luck and buy from another farmer next time. What if the potatoes are rotten again? He will either stop buying potatoes all together or will trade for much less meat. That is the fun of economy -- invisible hand to make everything just work :-)

ChampDog said...

True, this is just hypothetical. In reality, as you said it is just not as simple as that and you give a very good example on that.

I hope this at least can help people to understand the economy better in the most basic fundamental. Glad that you think that at least it makes it easier to understand. :)

Michael Tsen said...

is the recent sub prime crisis a result of 'modern' economy ?

ChampDog said...

In a way indirectly yes, I think. But, I’m not sure how to link that up as the sub-prime crisis is way far complex than this example. Anyone?

With the invention of money and etc, we are no longer trade with physical products or services.

What we trade now is probably no longer a real thing but just a virtual representation of the value of the products.

This eventually make the things getting more and more complicated because 1 oz of meat could be $1 or $1000 :)

Michael Tsen said...

well, my layman version of the stories that follow yours is

1. after trading for a while gold is 'defined'

2. then currency is created

then

3. today's problem

4. and upcoming future problem

ChampDog said...

That is the good one! :)

Michael Tsen said...

I think this story of yours is excellent, so I cann't help but to extend the story in my blog. Here is the link It basically explains why such a perfect trading plan 1+1>=3 can turns into problem today ... hope some of you will enjoy too.

ChampDog said...

Thanks for continue the sorry of this farmer and rancher. It is the good one especially explaining how poor gets poorer and rich gets richer.

As I commented in your blog, that the poor feel they're getting richer because they're getting more but in fact they're becoming poorer? Oh boy, what shall the poor do?

niki yokota said...

looks like you have a computer brain champdog chan.
im still confused lol

ChampDog said...

It is not really computer brain, probably can considered as economy brain? Anyway, I'm just beginner and still have a lot of stuff to learn.

I know it is confusing somehow. I think just remember the following will do:

(1) The economy exists is simply because everyone is trading.

(2) We trade is mainly because we can get the benefits out of it.

(3) Trading won't stop and will be continue because it brings benefits to everyone.

This is in general how the economy was started and continue until today. Hope that at least clear a little bit of confusion here. :D

Little Dough Girl said...

Wow! I have never seen anything so simple and so complex at the same time. Great job.

ChampDog said...

Simple as the one I commented and complex as the one I posted? :)

nyegik said...

wow is nice.....you make me understand right now

ChampDog said...

Thanks! I'm glad I did that.

stock market for beginners said...

Thanks for the article! Really great. I learned a lot of lessons.

Anonymous said...

This makes perfect mathematical sense. However, I fail miserable when I try to grasp this at intuitive level. Can you explain or refer to sources that explain why is this the case? Why do both parties benefit? How can it be that Farmer, produces less and still benefits...and also the other guy produces more and ALSO benefits o0

Are there also more examples of this? Would really love to know, spent over an hour trying to grasp this example and it was really worth it o0 didn't expect this would be true wow

ChampDog said...

Thanks for the comment. If that makes perfect mathematical sense, I'm not sure exactly what you still don't understand how it benefits to both parties. Perhaps if you can give more specific questions, I might able to help. :)

Anonymous said...

I don't understand how to take this principle of synergy and apply it to everyday life if you own a business for example. I have a sense these principles can be taken and applied in a business for example if you have 3 employees and calculate how to maximize the output.

I think your example is one example of the division of labor, right? So if the 2 personas worked in a business and did this they would be able to maximize the output of that biz by producing 1-2 extra pieces of food.

ChampDog said...

Thanks for the clarification.

It is about focusing on what you are really expert in and KNOW how to make use of OTHERS expertise.

This is how the economy works and how a company works too. Each department, each employee has their own defined roles on what they're suppose to be expert in.

Honestly I don't have a specific example (with numbers or any calculation) to show this because in reality, this is a lot more complex. We use 2 person (i.e. farmer and rancher) to simplify a very complex problem here.

As for maximizing the workers throughput, in manufacturing, statistic method is being used. In R&D, other methods are used (maybe no method at all). I'm not expert in those field.

I'm not sure if I answer you question but thanks for asking. Feel free to let me now if you have further comment and this is really a good discussion.

rubiks said...

i like the analogy, but you should have included something about services, and maybe explained how money works into the whole equation. Something like, "if you do this for me, then i'll give you some money to buy goods and services", ex..

ChampDog said...

Thanks for he suggestion. My next topic was actually related to money after this post. I"m not sure if this is something that you're talking about?

Anyway, you can check it out here: What is Money and Why It Was Created.


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