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Thursday, January 27, 2011

Money and its Evolution and Use in Society: Part II

By: Michael Richards
Goods are not merely consumed, but are produced for consumption. One of the greatest discoveries by the founder of the Austrian School of economics, Carl Menger, is the hierarchy of production. Basically, goods at the lowest order of production are those that are consumed. The goods used to make the consumption goods (production goods) are placed at a higher level based upon where they fit in the production process.
Murray Rothbard used an example of making a ham sandwich in his book, Man, Economy, and the State, to illustrate this principle. The sandwich itself is the consumption good and thus the sandwich is at the lowest level of production. The goods used to make this sandwich are the bread, ham, and cheese and thus are goods of a higher order in the production process. Still higher on the production process are the goods like milk, wheat, flour, and the pig. This example is used to simplify the process as one could go on for days explaining the whole process of machinery, transportation and labor involved in the process of making a ham sandwich. Note, however that these things are also part production process at various stages.
Money is used as a medium by which individual's exchange goods in society. Individual's use money to determine the cost and benefits of producing a product. Entrepreneur's make goods hoping that they will be valued by society. Nothing is produced unless an entrepreneur or allocator of resources expects that society will value the product. However, such knowledge is not known with one hundred percent certainty and are only determined by profits and loss on the market. Thus making the entrepreneur an essential part as a speculator in determining the prices at which profits can be made.
Money is important in this process as it is the common medium of exchange in society. People buy goods with money that they make either through labor or selling their own goods. Goods are allocated based upon the principle of profits and losses at all stages of production.
For example, how does a person who makes milk know that he should sell it to the man who will turn his milk into cheese? Why not sell it for direct consumption or for some other purposes? Also how much milk should be diverted in society for the production of cheese or cream and how much for direct consumption? This is answered by prices in a free economy of private ownership through the pricing mechanism.
Let's say we have a person who is making ham sandwiches for consumers to buy. He determines that he needs cheese, so he goes and offers to buy cheese from a person who produces cheese. The cheese producer will then look at the price this person is offering compared to the prices that other customers, such as a pizza maker, is offering. Another great discovery by Menger is the law of marginal utility. People don't want to buy all of the cheese but instead wish to buy them in units. So the pizza guy may want 100 pounds of cheese, while the ham sandwich producer may only want 50 pounds as this is the amount of cheese necessary to make their businesses profitable. Buy too much, then they have too much in stock and thus suffer losses. Buy too little and that 's profit they may miss out on.
So how are prices set then? Prices are grounded in the consumers' subjective values. If a large number, let's say 100 of consumers are willing to pay for ham sandwiches at 5 dollars, but only 40 customers are willing to pay for the sandwiches at 10 dollars. It is obviously more profitable to sell those ham sandwiches at 5 dollars as the volume of customers is higher than at ten dollars (100*$5= $500 compared to 40*$10=400 dollars. The number of consumers and the price they're willing to pay is what determines what will and will not be produced in the market. Of course the same goes for the sandwich maker. If the price of cheese is too expensive to make a profit, or if he can make higher profits without it, then he won't purchase it from the cheese supplier. This is also true of the producer of milk as he decides what price to set to sell his product to the cheese maker, the cream maker, or simply to the consumer of milk.
Money plays an important role as a medium of exchange because it states how society values things that are produced. If the cost of production is too expensive and no one is willing to buy, then that means simply that the product is not worth producing and that further production is merely a waste of resources. Further if goods are produced at a loss in profits, then that means that the goods are desired but are produced using too much resources that could be used elsewhere or are simply inefficiently produced to be accepted by society.
Without these money prices it would be impossible for the cheese maker to know whether to allocate those resources to the sandwich maker, supermarket, pizza maker, or anyone else who wants to use it. As goods move higher in the scale of production, money prices become more useful in allocating resources in a way that will most please the consumer. It is important that these are market prices based in consumer sovereignty at all levels of production. Thus meaning in a market economy of private ownership of production. Such a process does not exist in socialist economies as they lack the price mechanisms at various stages of production thus really have no means of determining what quantity of goods are to be produced at the higher levels of production.
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Money and its Evolution and Use in Society: Part II by Michael Richards is licensed under a Creative Commons Attribution 3.0 Unported License.

1 comment:

  1. I would like to remind anyone reading this is that this is going to be an example of how I am going to explain economic theory for people who don't know economics. So please leave feed back if anything is complicated or if I should simplify these principles to be better understood by my audience.