Thursday, August 23, 2012

Mr. Smith and Mr. Keynes

Once upon a time there was a town with only two people, Mr. Smith and Mr. Keynes.

Mr. Smith was as odd duck who was constantly forgetting things and liked to go for long, solitary walks in his leisure time. He was of a generally amiable nature and sometimes said the most insightful things, but then would break off and stare into space as if he had forgotten you were in the room.

Mr. Keynes kept up appearances but at heart was a bit queer as well. He was cleverer than almost everyone else and knew it; conversations with him invariably left one with a sense of admiration and inferiority. But he worked hard to help his friends and help his country, so you couldn't hold his attitude against him for long.

The town where Mr. Smith and Mr. Keynes lived lay in valley of bounty. Most everything grew on trees, and a stream of bright, fresh water ran through the center. In fact, the locale was so rich that to meet their needs Mr. Smith and Mr. Keynes needed to produce only two goods: bread and beer. The bakery was located at one end of the valley and the brewery at the other, and it took about an hour to walk between the two.

At first Mr. Smith and Mr. Keynes each split their time between the bakery and the brewery. Mr. Smith was a bit better at brewing beer and Mr. Keynes was a bit better at baking bread, so one day Mr. Smith said to Mr. Keynes:

"Why I say John, if you did only baking and I did only brewing and then we swapped, we could each save an hour of time spent working and an hour of time spent walking!"

Mr. Keynes considered this thought carefully, his mind whirring with critical intensity.

"You are right that we would each save an hour working, Adam, but we would still have to spend half an hour each walking to meet each other in the middle of the valley. And what of the terms of the exchange? How are we to decide how many pints of beer are worth one loaf of bread?"

 "That's right, that's right John, I hadn't thought of that." Mr. Smith leaned on his cane and contemplated the valley for about thirty seconds. "But still, we'd be jolly better off, wouldn't we, each saving an hour working?"

And so Mr. Keynes and Mr. Smith became, respectively, the baker and the brewer in their little town of two. In the end it took them only half an hour to negotiate the swap, so their arrangement saved them each one hour of time. They decided to spend their extra hour baking more bread and brewing more beer, and by eating and drinking more in the evenings they both became a bit more jolly and a bit more fat.

All went well until one day Mr. Smith saw an unusual bird from his bedroom window in the morning, and spent the day wandering the hillside thinking about wingbeats and government. When Mr. Keynes arrived in the middle of the valley with his bread at the appointed time, Mr. Smith was nowhere to be found. Mr. Keynes went home rather steamed and when he woke up the next morning he thought to himself, "If that Smith doesn't show up again today I'll have wasted half the day! He considered the odds, and decided that he would spend part of his day baking and spend the rest of his time reading about ancient Babylon by the stream. If Mr. Smith remembered, he would at least get some beer, and if Mr. Smith forgot, he would at least not have wasted all of his time.

And so life went on. Some days Mr. Smith remembered to brew and some days he forgot, and occasionally even the reliable Mr. Keynes failed to bake because he had traveled to the city to see the Russian ballet. Both Mr. Keynes and Mr. Smith began to produce less than they would have had their faith in the other been absolute; but as it was neither could deny the logic of hedging the possibility of a no-show with a bit of extra leisure time reading by the steam.

The town of Mr. Smith and Mr. Keynes became an economy subject to three and only three constraints: the constraint to production, the constraint to exchange, and the constraint to information. The constraint to production was eased when Mr. Smith and Mr. Keynes decided to divide labor and become the baker and the brewer; because of their differing skills and comparative advantage, the tiny town was able to produce more bread and beer in the same amount of time as it had before. The constraint to production would also have lessened if Mr. Smith had bought himself a modern brew-kettle or Mr. Keynes had installed an Easy-Bake Oven.

The daily walk to the center of the valley and the time spent negotiating the swap comprised the constraint to exchange; and likewise would have decreased with the introduction of new technology, such as a boat to port beer and bread on the stream or scale for more accurately weighing and comparing the respective products of Mr. Smith and Mr. Keynes. The constraint to production and the constraint to exchange can also be thought of as capacities; the maximum product of Mr. Smith and Mr. Keynes being the capacity to produce, and the maximum exchange of Mr. Smith and Mr. Keynes being the capacity to exchange.

The constraint to information was the uncertainty Mr. Smith’s absent-mindedness and Mr. Keynes’ love of ballet created; neither party knew if the other would appear at the appointed time of exchange, or even knew the precise probability of the other’s appearance. Without perfect information, they had to rely on trust. If Mr. Keynes expected Mr. Smith to arrive with beer, he would spend little or no time relaxing by the stream. If he had no faith in Mr. Smith’s memory, he would spend more time relaxing and make less bread. Imperfect information coupled a lack of confidence kept the economy of two from producing and exchanging as much as they would have had information been perfect, or faith absolute.  Collectively, Mr. Smith and Mr. Keynes' interpretation of limited information can be termed the state of expectation. 

The purpose of this blog will be to explore the idea that all economies of all sizes and all complexities are entirely defined by these three constraints.

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