What is money?

Story 1
Say, you are stranded on an island and you only know how to collect coconuts and catch fish. Then the cost of coconuts is the amount of fish you cannot catch while collecting coconuts. Similarly the cost of fish is number of coconuts you cannot collect while catching fish.

Story 2
Say you are stranded on another island with a beautiful girl. 😉 She knows how to forage for watermelons and she can collect coconuts too if she tries really hard. But she is not strong enough to climb on coconut trees. So her costs of coconuts is very high because, she has to sacrifice a lot of watermelons just to get one coconut.

On the other hand you can collect both watermelons and coconuts equally well. (No fishes in the nearby sea this time).

So each on your own, produces what each wants, and this is called self-sufficieny. But your girl, uh.. I mean the girl wishes that she did not have to work so hard and sacrifice so many watermelons just to get a mere balanced diet with one coconut in it. This means she has more utility for coconuts than you do.

In such a situation, it can be proven mathematically that this tiny economy can produce more than what it produces during self-sufficiency (i.e. when each is on its own) if they chooses to specialize in their talents and trade the produce.

So she teams up with you. You collect coconuts all day. She collects watermelons all day. At the end of the day, there will be a particular rate of exchange at which both of you will find it profitable to exchange some coconuts for fish or vice-versa. She would say, “Hmm.. I can get coconuts from this douchebag by sacrificing fewer watermelons than I would have to sacrfice if I were collecting both on my own”. You would say, “Hmm I can collect both equally well, that means I sacrifice one watermelon to get one coconut. But this pretty babe is stupid enough to give me a lot of watermelons just for one coconut!!”.

So you both of you think you are the one who is profiting in the trade, whereas what both of you have done in fact is to have invented a mechanism to effectively produce more by spending less. This is capitalism.

There are 2 pre-requisites for capitalism to work (and let people spend less to achieve the same level of production and happiness as they would have if they produced everything on their own):

  • Property Rights: There should be some formal/informal way to own the coconuts or watermelons you produce for them to trade. In a Marxist/Communist economy or in free and open source software, nobody owns their produce.
  • Scarcity: There should be an actual scarcity of the goods in question for people to produce more and profit. Coconuts and watermelons available on an island are not infinite in quantity. But there can be infinite copies made for open source software.

Story 3
Let us say you are stranded on the same island with the same girl as in Story 2. After a few years you discover that there are certain pretty stones both of you would like to have, but there is only a fixed supply of these stones. You cannot find more by just looking for more. In such a situation it can be proven that both of you will eventually end up using these stones as the common medium of exchange for all goods. This stone does not perish, and it has become the money of your tiny little economy.

(e.g. in POW camps of WWII, prisoners used to use cigarettes as money to trade for rations because cigarettes were the most scarce).

In modern economies, money is a product whose supply is controlled by the government so that they save the economy if it drops into a depression/inflation/deflation. So when people say prices of everything is going high, it means the money in circulation is high because less people are unemployed.

P.S: Based on the morals of story 2, it is easy to see why globalization is a good thing for the world.


One thought on “What is money?

  1. Even though I prefer to avoid your blog entries dealing with theology and economics because they seem so boring to me. But after reading this, I don’t think your way of explaning economics to n00bs is boring at all, so dude start categorizing your blog entries, uncategorized sucks 😛

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