May 5, 2024

by Stephen Stofka

This week’s letter begins a series of subjects related to income and consumption. I will start with income, how we get the money to buy the goods and services we consume. A first-year course in microeconomics conveniently and simplistically divides the world into consumers and producers. In their textbook titled Microeconomics, Krugman and Wells (2018) explore the subject of labor as a factor of production in Chapter 19 at the end of the book. Since most of us work for forty to fifty years, the subject could be introduced to students in one of the early chapters. John Maynard Keynes, schooled in neoclassical analysis as a student of Alfred Marshall, criticized this framework because it ignored many of the flows in an economy. In a modern economy, we implement our choices with an exchange of money. Where did the money come from?

An entrepreneurial attitude to work is this: we either work for money or money works for us. If we work for money, money is our boss. If money works for us, we have a responsibility to direct it and manage it well. In that framework, money is a factor of production, the capital we use to realize goals for ourselves and our family. I was first introduced to this notion of money working for me when I was a child, and my folks opened up a savings account for me. I was amazed that my birthday money did chores just like a real person and got an allowance called interest. As the money got bigger, it worked harder and got a bigger allowance. What an amazing system!

Adam Smith, the first economist, analyzed the exchange of goods and money as a system. In the Wealth of Nations, Smith (1776; 2009) emphasized that the key to a developing economy was the subdivision of tasks to become more productive. Higher productivity created a surplus of a good or service so that the producer was willing to trade with someone else who wanted that good or service. In Chapters 2, 3, and 4 of Part 1 he repeats the point that this imbalance of supply and demand provides the energy to an economic system. In an often-cited example, Smith recounted the efficient production of a pin factory where each worker is assigned just one step in the production of a pin. An economy grows as the division of labor becomes more complex.

In Part 5 of the book, Smith predicted that the increasing division of labor would lead to greater prosperity but unevenly distributed. “For one very rich man there must be at least five hundred poor,” he wrote. Such inequality could lead to violent anarchy because the “avarice and ambitions in the rich” clashed with the “hatred of labour and the love of present ease and enjoyment” by the poor. A sovereign government had a responsibility to keep order and protect people from each other. Secondly, it should provide public works and institutions that distributed the benefits of a growing economy to more people. A road or port does not provide enough benefit to any one person or group to justify its expense, but such public projects raise the productivity and standard of living for many. Smith saw this improved public welfare and private security as key features that distinguished England from less-developed economies. To Smith, government was an intermediary between parties just as money was an intermediary of exchange.

A cost-benefit analysis of an exchange of surplus reveals some interesting ratios. A seller with a surplus of a good values the benefit from the good less than the buyer does. On the other hand, the cost to the seller includes the opportunity cost of not producing something which would earn a higher price from a buyer. The commitment of capital or time to producing a good or service requires a choice between alternative uses of that capital or time (see notes for measurement of opportunity costs). Presumably, the ratio of benefits equals the ratio of costs. If not, there is less motivation for exchange between seller and buyer. A less developed economy like Brazil generates less surplus so there is less inducement to make economic trades and money circulates at less than a third of the speed that it does in the U.S. (Notes).

The concept of surplus helps us distinguish different types of exchange. When two people trade services, they trade their labor, which has no surplus as such. To barter their labor, buyer and seller must match the type of good or service to be exchanged. To each party, the benefit must equal the cost, a hindrance to exchange. In an economy promoting the production of surplus, the benefit and cost are unequal to each party, but the ratios of benefits and costs are equal. Matching is easier and there are more trades.

Can we apply this analysis to the exchange of securities? The seller of a security like Apple’s stock does not have a surplus because she produces Apple stock for sale. She is motivated to sell because she thinks it might go down in price, and the benefit she receives from the sale is greater than the cost if she held onto the stock. The buyer thinks the security might go up in price, so his benefit is also greater than the cost. The key to this transaction is the broker who produces trades for sale, the matching of security transactions. The benefits to the buyer and seller of the stock are greater than the benefit to the broker. The broker’s cost, including the opportunity cost, is greater than either the buyer or seller of the security because the broker could always make more in commission by facilitating a different type of trade.

A year ago, I spent a few months studying the dynamics of a developing country in Africa. Because there was a lack of surplus in some parts of the economy, I came to appreciate the key role that surplus plays in our lives. In the coming weeks, I will try to understand various aspects of our working lives through these ratios of seller and buyer costs and benefits and how those ratios are influenced by surplus.

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Photo by Adam Jang on Unsplash

Keywords: securities, stock, cost, benefit

Krugman, P. R., & Wells, R. (2018). Microeconomics (Fifth). Macmillan education.

Smith, A. (2009). Wealth of Nations. Classic House Books.

Brazil Money Velocity: In the third quarter of 2023, M1 velocity for Brazil was .35, meaning that money circulates a rate that is a third of GDP output. The same velocity in the U.S. was 1.5, more than four times the rate. Brazil M1 measure is MANMM101BRM189S. Final demand, a measure similar to GDP, is  BRAPFCEQDSMEI. There was not a current measure of M2, a broader measure of money often used in the U.S. The series for M1 velocity is M1V.

Physics Imbalance: Coincidentally, an imbalance in electron fields causes atoms to bind together in an exchange of electrical charge. Khan Academy has a short explanation with graphics.

Opportunity cost: this is a fundamental concept in economics, yet economists disagree on how it should be measured. In 2012, Potter & Sanders justified four different answers economics graduate students gave to the calculation of opportunity cost found in an introductory economics textbook.

Potter, J., & Sanders, S. (2012). Do economists recognize an opportunity cost when they see one? A dismal performance or an arbitrary concept? Southern Economic Journal, 79(2), 248–256. https://doi.org/10.4284/0038-4038-2011.218