By Ron Burgess for MicroGiants
Many small business owners tend to think of the economy as something so big that they don’t study it. Over time they certainly understand the effect of changing interest rates, taxes and government interference in their particular industry, but still, that tends to be the extent. So without opening this large can of worms, here are my thoughts about some important basics of economics.
I was the same. At first, I watched my industry and the general economy, for protective measures to my businesses. As I branched out to other industries, I spent more time reviewing what I thought I had learned in business school about economics (John Maynard Kayne’s and John Kenneth Galbreath) only to realize that the text books that I studied were written by men who I now see as “progressive.” In other words (and very generally), they believe that government has a large role to play in shaping the economy.
Everywhere I looked, I saw government intervention in my business. Certainly safety is an important part of government’s role. It can influence the economy and stifle small business, yet we all want safe working conditions and generally safety in our lives. So we are willing to give up something for safety. Most of us are willing to pay a little more for electricity to keep miners safe and gas explosions from happening. That small cost barely tips our notion of energy value.
But today, many, many other laws and regulations affect the economic welfare of small business. This, in some part, is due to the influence of the post-depression economics of the economists mentioned. If a problem presents itself, let the bureaucrats fix it. As a result, the bureaucracy has grown many times larger than the depression era, and hundreds of times larger than our founding fathers would even conceive of for a “free” people.
So I began my quest to better understand exactly what economics are, and how we came to this place.
The story of economics starts way back when two people liked what each had made, hunted or grown, and wanted to trade. Each had different skills, geography or natural resources. So each could benefit from the trade. Bartering, say, fish for arrowheads, required a discovery of sorts on price. The skilled arrowhead maker, knew how many arrowheads he could make a day. The fisherman knew how many fish he could catch each day. The arrowhead craftsman may have been the only one for miles around, while everyone locally could fish just as well as the next.
So, depending on how badly the fisherman needed arrowheads, he might have traded more fish on one day than on another because he had more competition. The arrowhead maker also knew that he could make a better trade in the next village, so he wanted more fish for fewer arrowheads. Together they bartered a price that satisfied both, and a trade was made!
This example explains most of what micro-economics is. We usually describe it as supply and demand. As a concept, it is deceptively simple, yet it has some very complex twists and turns. For instance, if the price of fish gets higher than the arrowhead maker likes, he may simply trade for a squirrel. In this case, a squirrel (or opossum, rat or dog for that matter) are all substitutes for the fish.
The first time this happened of course the fisherman realized that he was really also in competition with hunters of all kinds. But it goes further. If all meat is too high for the arrowhead maker, or he develops a taste for bread, or even Mead (a fermented drink at least 9,000 years old). So, the fisherman must keep his prices competitive with all food. This substitution relationship is key to keeping prices and values in line. Based on this wide variety of options, two people can each determine their own value for each object, and together if they come to a transaction, they both benefit.
Of course each can also customize their offerings to make them different and more desirable for the next trading session. The fisherman may smoke the fish using his own special hickory wood, making it ready to eat and perhaps more valuable. The arrowhead maker may add better notches for securing it to an arrow. We all do this today. We call it an improvement and try to brand it as our own. “Let’s go over and trade for some of Otzi’s smoked fish for dinner tonight.” Otzi’s Hickory Smoked Fish is born.
A few millennia later, a Scot named Adam Smith began to build on a professor’s (Francis Hutchinson) thoughts in “political economy” and eventually wrote the landmark book in economics. I learned that pure economics do not involve much government at all. Notice how our two traders got along without government overview?
He stated (among many other thoughts) that two people (traders) who are looking out for themselves in a purchase, can both be satisfied on quality, price, and service when they agree to a transaction. In other words, if they look out for themselves, they can find the best trading solutions based simply on self-interest. Many critics have twisted this to be selfish interest, but it is not the same.
Only the buyer can determine if they can or should pay a certain price for something. The town council, state government or even the federal government cannot possibly watch each and every transaction to determine what the value of anything is. Yet governments try to do this all the time and constantly.
Adam Smith recognized by simply watching transactions in the local market between merchants and buyers, that they each came to an agreed value on their own, base on supply, demand and substitution, and the amount of money (or time) the buyer had. Milton Freedman expanded and confirmed this concept in modern times.
Each person has a different value for his time based on the supply and demand his work. So the value is different for every item and every person. When a price is posted, in a free country, you can either buy it or reject it based on your own determination of value.
This ingenious system was discovered not invented. Adam Smith and Otzi both simply used logic and common sense to make the trade happen. They were mostly aware of how many substitute options the other trader had and made the price according to the value of his own time. In other words, his own productivity.
Realizing this, each tried to work harder or longer to increase their own production value. When Otzi’s wife, Ayla said she needed a new cooking bowl, Otzi would be out fishing late into the night to catch more fish. He then said, “Ayla, you’re going to have help me smoke all the fish, I’m out of time and working my fingers to the bone.” The first family business was born! Who knows after the children were put to work they may have even hired an employee.
And what is the lesson that applies directly to your business?
First, make products that are valuable to customers. Differentiate them with service, quality or low price. If you can, brand them to take advantage of reputation and expectations. This increases value too. (See more about this concept on the Burgess Value Diamond in this MicroGiants blog in the Tools Category).
Second, always work to find ways to increase quality and decrease production cost. While inflation tends to increase costs, the point here is to increase your productivity without increasing your time. Otzi used his family, but hopefully he also built a larger smoker for more fish at the same time. He may have also found a better way to use less wood and increase the confined smoke more effectively.
Finally, if you are inclined, try reading Adam Smith’s “An Inquiry into the Nature and Causes of the Wealth of Nations” (1776). This was published just in time for our founding fathers to read before they wrote the US Constitution. These principles were built into our government with the attempt to keep government mostly out of economics.
Economics is mostly simple, but made difficult by macro measurement techniques and those wishing who think they can outthink the nature’s economy. In is pure form it takes care of itself.
Want to know more about Adam Smith and Milton Friedman? Check out this excellent video.