On how a Cup of Coffee makes the World go round

As I am writing this post, I am sitting at a café shop near my campus, sipping a latte. The small cup of latte I’m enjoying right now costs me about $2.5 (USD), a price point that makes both me and the café owner happy.

With the $2.5 it costs me, I get a good quiet place to sit and work on my article (on top of the latte I’m enjoying). With the $2.5 earning from me, the owner is able to cover whatever the materials went into that cup of latte, and the amount of earning that’s left will go to the labour, the cost of the brewing machine, the utilities expense, and profit. Ultimately, everybody wins.

It is probably not obvious, but the above example teaches us a very important economic lesson.

It shows that this simple economic transaction benefits both parties, the seller and the buyer, which implies that “price” is subjective. Why is that? Because otherwise, the transaction would not have satisfied anyone and it would not have occurred in the first place. Think about it for a moment. For me, a consumer to be willing to pay $2.5 must mean that this latte is worth more than $2.5 to me. Thus, I derive a positive net benefit from the transaction. Otherwise, there is no point to make the purchase or I would simply be indifferent between buying and not buying.

Likewise, to the shop owner, this $2.5 she received must be worth more than that cup of latte to her. Otherwise, it wouldn’t make sense to sell it to me.

Hence, to each individual involved, the transaction is worth more than what they initially had in hands, and this very idea of “subjective price” is at the core of the economics discipline.

First, it explains why transaction occurs, and second, it shows that whenever a transaction occurs (assuming no fraud and all the shenanigans to mess things up), then all parties involved are better off. Note how I used the word “involved”. That means that there are times when a transaction (ex: your decision to smoke) can make the uninvolved or uninformed parties worse off (other people around you), i.e. the idea of externalities.

But, forget about this for a moment because in a well-regulated economy with all the cornerstones (property rights, law enforcement, etc) in place, such negative spillover does not happen quite often (even in a poorly regulated one, the benefits of millions of transaction would outstrip the cost anyway).

Moreover, in addition to raising utility (think of it as satisfaction), transaction also raises everyone’s earning. This can be explained via a simple economic idea that “spending equals earning”. The more transaction occurs, the more people spend. When you spend your money, someone else gets paid; hence, the more transactions, the more earnings.

For this reason, the volume/number of transactions is one of the major variables in economic growth, and there is an economic model for it (but I’m not going to be too technical here). The larger the volume of transaction, the more rapid growth we get. That is why free market that gives individuals freedom to invest, borrow, loan, buy and sell (basically, to transact) works so well in boosting growth. That is why capitalism that guarantees private profits (you reap what you sow) is a great mechanism to increase GDP.

That is why rules of law and government’s interventions (in form of policies/regulations) that inhibit transactions or reduce the number of transactions are harmful to the economy as they slow down growth.

So, in analyzing a policy, it is not just how the policy affects income and investment (or inflation, interest rate, etc) that we should care about, but also how that particular policy discourages or encourages transactions between individuals. For example, a tax policy almost always exerts cost on the economy because higher tax discourages transaction. Therefore, government spending (using tax revenue) is not efficient unless it generates substantial long-run return to offset the loss resulted from lower volume of transactions/exchanges. Educational subsidy is thus a good policy because it gives rise to higher potential growth in the long-run. Agricultural subsidy, however, needs more scrutiny because it can result in downward price rigidity, inefficient agricultural practice, and oversupply of agricultural products, all while lowering the transaction volumes in many other sectors within the economy.

A compassionate patriot is, thus, not necessarily a good policy maker.

And that’s a wrap.

Economind