So Why Do We Need This Stuff Anyway? What is Money?

Having discussed the form of money, I feel I should go into some detail on its function. As I said before, I’m not an economist, I just play one on teh interwebz. Money serves three major rolls in the market. First, it acts as a medium of exchange, allowing people to trade with anyone in the market without having the specific good their trading partner wants. Money also serves as a measure of a market actors desire for a particular good. The last function I want to discuss is that of information, allowing an individual to make the best decision in any given market situation

A medium of exchange is perhaps the most basic of the functions of money. Without money the fisherman who wants a chair has to hope that the furniture maker wants fish, whereas if money is around, he can trade his fish to anybody who wants fish, weather or not they have a chair. He can then take the money he received for his fish, and trade that to the furniture maker, even if the furniture maker has no desire for fish. This facilitates trade among individuals whom recognize a particular form of money. Without recognition as money, even gold cannot purchase things, except from people who want gold. It is this widespread recognition by multiple individuals that gives gold, silver, or paper its power as money.

Most people don’t think of money as a measure of an individuals desire for a good, but it does serve this purpose. Let us suppose that Alice has $50 and wants an MP3 player. At the store she sees they have 2 models on sale, A)a 2GB for $25 and B)a 8GB for$50. In simple terms of price per gigabyte B is the better deal, and the better apparent value. The question is whether or not Alice values the extra storage at $25, the difference in cost. If Alice values the storage at $20, she won’t buy player B unless the price comes down, and will take player A instead. If Alice valued the extra storage at $30, then she would see the price on player B as a great deal, and buy it.

To see the use of money as information, we need only look at the other side of Alice’s MP3 player purchase. Let us suppose first, that Alice purchased player A. This tells Bob, the store owner, that a customer values $25 more than they value 6GB of storage space in an MP3 Player. If enough customers send this information by purchasing player A, Bob would likely react by either 1) lowering the price of player B until it reached a point where player B was purchased more, and A less, or 2) raising the price of A, thus reducing the cost of the 6GB of storage, and perhaps encouraging purchase of player B. Bob could also choose to do nothing. All three of these possible actions come with risks to take and rewards to gain, and any one of them will give Bob more information to make a better decision. If Bob takes action 1, he runs the risk of lowering the price to a point below his cost, thus taking a loss on the 8GB MP3 players. It gives him some information on what his customers are willing to pay for MP3 players, and encourages him to find a better price for his supply. Option 2 runs risks, in that he may raise the price of player A to the point that his customers aren’t willing to buy that player either, and in addition, rising prices tend to drive customers to competitors. Bob would gain information on how high he could raise the price of player A without losing customers, though this can be difficult to measure, as you can’t count customers who don’t exist because they did go to the competitor. Doing nothing may seem like a good idea, but soon enough Bob will find himself holding on to those MP3 players that are unwanted, and as technology advances, he may soon be able to profitably sell new 8GB MP3 players for $25, and is likely to take a loss on the ones he purchased first and couldn’t sell at a profit.

Now let us suppose that Alice purchased Player B. Bob now receives an entirely different set of information, and would need to take different action to maintain profitability. Bob now knows that a 2GB MP3 player is valued at less than $25, when an 8GB player is available at $50. Again assuming this is a general trend, Bob has a few options, 1) reduce the price of player A, 2) Raise the price of player B, or 3) do nothing. Option 1 runs the same risk in this situation as previously, and offers the same information and encouragements. Option 2 is even more risky now, as he may end up stopping his sales of MP3 players completely. Again, by doing nothing Bob may find himself holding a lot of obsolete merchandise that he can only ever sell at a loss. Without money to serve its vital function of sending the profit/loss signals any market actor would be hard pressed to accurately determine what his customers want, and what they are willing to give up to get it.

Clearly by acting as a medium of exchange, both in goods, and in information, money is a vital tool to the conduct of business in any market. A pure barter system with no money to serve as an exchange medium results in wasted time and resources as each market actor must find a person whom both has what they want, and wants what they have. By helping to quantify desires money enables the customer to make the best decision for how to spend, and it’s importance as information in profit/loss signals is the driving force that allows markets to be self-correcting. Money is the heart and soul of any economy, and well worth understanding.

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Published in: on March 22, 2010 at 3:05 pm  Leave a Comment  

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