Wednesday, July 18, 2012

Economics and The Theory of Value (2)

Profit in the Subjective Theory of Value:
In the previous part, we discussed Karl Marx's theory of exploitation, and the thesis that profit is made though exploitation of one person of another. The subjective theory of value provides an alternative explanation of how profit is made in trade.

Let's review the story of Mr. Jesus Lover and Mr. Jesus Hater discussed earlier. In that story, Mr. Jesus Lover got a T-shirt as a gift with "I hate Jesus" written on it. Mr. Jesus Hater got a T-shirt as a gift with "I love Jesus" written on it. In this scenario, both of these individuals have negative valuation of the items they have.

Unlike our previous example, in this scenario, those individuals don't know each other; So, they are not going to engage in direct trade. Instead, let's suppose there is Mr. Trader. Mr. Trader meets Mr. Jesus Lover and offers him 6$ to get that shirt. Later, Mr. Trader meets Mr. Jesus Hater and offers him another 6$ to get that shirt from him.

Note that each of these trades are good bargains for these individuals, since for each of them, the shirt they have is worthless; But now each one of them has 6$ instead of a worthless shirt!!

Suppose now that Mr. Trader puts these shirts on sale. He offers both shirts for 10$. Let's assume that Mr. Jesus Lover values the first T-shirt for 12$, and Mr. Jesus Hater values the second T-shirt for 12$ also. Both of these individuals visit Mr. Trader's shop and buy their favorite shirts for 10$.

Let's examine what happened with this step-by-step table:

As we can see, Mr. Jesus Lover started out with a worthless shirt and 10$ in his pocket. He ended up with a shirt he subjectively values at 12$ and 6$ in his pocket. Giving him a total of 18$ in value. Mr. Jesus Lover has gained the equivalent of 8$ in this process!!

Mr. Jesus Hater started out with a worthless shirt and 10$ in his pocket. He ended with a shirt he subjectively values at 12$ and 6$ in his pocket. Mr. Jesus Hater gained the equivalent of 8$ in this process.

Mr. Trader started out with 12$ in his pocket, and ended up with 20$ in his pocket. Mr. Trader has made a profit of 8$ as well...

As a total for all people involved, we started with the equivalent of 32$ in value, and ended up with the equivalent of 56$ in value. The net gain for all people involved is the equivalent of 24$... Also, note that each step in this process increases the amount of value in the system, because each step is itself a positive-sum game as the people involved wouldn't trade unless each one of them subjectively views the trade as profitable.

By understanding this scenario, we learn three very important lessons:
1- In trade, everyone involved is a winner.
2- Trade CREATES new value.
3- In trade, profit is made in the process of different subjective valuation of the same commodities.

In our scenario, Mr. Trader profited from the process of transferring the ownership title of the two shirts, from the individuals who least wanted those items, to the hands of those who most wanted those items.

In technical economic terminology, profit is made by efficient allocation and reallocation of resources. In our example, the trader served to reallocate the existing resources (the shirts), from it's inefficient initial allocation (as worthless shirts) to their more efficient allocation (valued shirts).

Labor is a resource just like any other resource in the market. And business owners maximize their profit by allocating labor to it's most efficient use. This might not be easily understood as the trading example, and I will elaborate on this in future posts.

Trade brings profit by increasing the efficiency of allocating resources. In the T-shirts example, profit was made by goods simply exchanging hands. But, this is not the only way trade is beneficial. Trade also improves efficiency by conserving resources. See video below as another example of how trade increases efficiency of allocating resources in a more concrete sense.

In this series:
Economics and The Theory of Value (1)
Economics and The Theory of Value (2)
Next: Economics and The Theory of Value (3)

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