Tuesday, 5 February 2008

Desert island economics

Economic systems can be a little bamboozling, so I like to think about economies with a small number of people, see how they interact with each other, and watch how growth occurs there. Desert islands are sometimes taken as examples by other economists.

For example, on a tropical island with two people Alison and Bertha, let's say that they have enough to eat from coconut trees. Alison likes to hear Bertha sing and Bertha likes to see Alison dance. One day Alison makes Bertha an offer: I will dance for you, if you sing for me. OK, says Bertha, and twenty minutes later they have an economy with total value added of one song and one dance per day.

A few days later, Bertha finds out that Alison is not really tired after her dancing, so Bertha makes another offer: you dance for me for seven hours, and I will sing for you for seven hours. We can do lunch breaks as well. OK, says Alison, your sharp observation has improved the operation of the market. Let's do it. Total economy value: seven hours of song and seven hours of dance.

There's a shipwreck. Clare survives and drags herself on the beach, and reveals she used to be a civil servant. She's got an idea: set up something like a small government, and us three might be happier. Alison and Bertha agree to try it, and Clare levies a tax: every six dances that Alison does, she has to do one in a place decided by Clare (she promises that her decision will be in the public interest). Clare levies another tax: every six songs that Bertha sings, she has to sing one in a place decided by Clare. Alison and Bertha are not too happy about this, but cheer up when Clare clears some plants, and Alison and Bertha perform their three taxed songs and dances publicly for everyone's enjoyment.

There's another shipwreck, and Diana is washed on a beach. She's a dance instructor! So she makes Alison an offer: you dance for me, and I will teach you new dance moves. OK, agrees Alison, but I will not be able to dance for Bertha so much today if I am to invest in my human capital by paying for your dance instruction. So she dances for just six hours for Bertha, and one hour for Diana. Diana teaches Alison for one hour. That day, the total economic output is six hours of song, seven hours of dance, and one hour of instruction. Clare does not levy a tax on Diana's teaching, as she considers it beneficial to everyone.

The next day, Alison shows off her new dance to Bertha. It's so good that Bertha will sing for two hours just for one hour of dance from Alison. Alison uses part of the remaining time to get an extra hour of instruction from Diana, and part of the time to sun herself on the beach with Clare. The total output that day is seven hours of song, three and a half hours of improved dance, and an hour of instruction. Alison's human capital investment has resulted in increased productivity, which has led to increased output and increased leisure time.

Clare notes that the economy is getting a bit complicated for the purposes of accounting, so suggests setting up a form of money - coconut shells with an official marking on that only she can make with everyone else's approval. The others agree, and Clare makes a hundred marked shells and gives twenty five to each person on the island. She announces that the government will take tax only in the form of shells, and will pay in the form of shells - it starts by saying that one hour of song is worth five shells, one hour of improved dance is worth ten shells, and one hour of teaching is worth ten shells. Because everyone has to deal with the government regularly, they soon get used to pricing in shells, and even adjust prices as supply and demand changes. After a few days, the market sets prices more than the government.

Well, that's one way to set up an economy, with market exchange, market completion, capital accumulation, productivity and output growth, and money. With another three people and a dozen more paragraphs, you could have immigration, central banking, international trade, government transfers, institutional design, currencies. Pretty much all of the theory relating to modern economics can equally be applied in small economies, but is often far easier to understand in them. Even the theory of perfect competition, which assumes a very large number of market participants, is rightly being refined in modern economic work into recognition that the number of market participants is always finite, so individuals will affect the market when they make decisions.

My, this blog article has taken over an hour! Probably it will be useful in economics teaching though.

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