Money’s use: the unit of exchange

Picking up from my previous post on the value of money which talked about its use as the unit of account we continue here with the next benefit, unit of exchange.

So every good has two values, the first is its retail value, X. This is what people would pay for it because they want it (or need it). The second is its exchange value, Y; this is what people who don’t want it would pay for it and they would do this because they can exchange it later on. So by definition X should be higher than Y otherwise people would not buy it to sell it on since they would make a loss.

So, let’s take a situation. Let’s say person A wants to buy a cell phone, but the only thing he has in excess is a microwave.  So A goes to meet another person, person B (who has an extra cell phone) so he can exchange his microwave for the cell phone. It could be that B wants or needs the microwave, and if that’s the case, that’s what economists call a “double coincidence of wants”. In this case he will get fairly close to the X value of the microwave since person B wants it.

If however person B does not want the microwave then he will not want to exchange it. That is unless he is making a profit from this transaction, and the only way he can do that is by thinking he can exchange it for a higher value than he will get it for. So person A will get a value close to Y in this case.

This difference between X and Y is the cost that person A will suffer in the second but not the first scenario. It is the second transaction cost that takes place without money.

As I mentioned before, money is essential to the division of labor of society.As a last demonstration of division of labour’s important to the exchange value, let’s imagine that a bakers TV broke down. Without the presence of money, he will have to spend hours and hours on end trying to learn how this works, and then fix the TV. These hours are of considerable value to people, but with money, the baker can essentially fix the TV by baking cookies. He has the ability to liquefy his effort and make it take any form he wishes it to without suffering much of a transaction cost at all. I find this amazing, how you manage to achieve everything people can do with equal efficiency by doing just one thing what you can do most efficiently. That is unless labour prices are distorted.

Now so far we have assumed that both parties know the true value of what is being offered. If however B does not know what A’s product is worth the transaction is crippled since B would need to be educated. This education process is costly and if he is exchanging it for the purpose of reselling it, then he might also expect that who he sells it to will also need to bear an education cost. So the price person B will pay will be Y minus the cost of acquiring this information, which means A got even less value out of his product.

So in our economy with millions of products, we can introduce money and what this does is make X=Y.

Money isn’t some artificial thing that was dreamt up, it was a spontaneous process, one where people saw immediate benefit from its use. There was no real need for government to issue currency as medium of exchange; historically gold and silver fulfill an equally good role. The criteria for a good medium of exchange are durability, portability, recognisability, divisibility, homogeneity and scarcity (this one is tricky with elastic money). As a side effect, when something becomes the medium of exchange, its value is no longer determined by its intrinsic value but by its value for trading.

As a final note, it should be obvious that money is only worth something in the context of the economy’s output. If you have 10% of all money in the economy, you essentially own 10% of value of the economy. So printing money doesn’t really create value, it merely increases the medium with which to exchange things, the amount of things to exchange has not changed.

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