In my last Pulitzer-winning entry to this blog, I wrote about money, and how it replaced the barter system. To see this previous entry, you'd have to scroll down.
Well I kind of lied. It didn't replace the barter system, it just made it easier to work with. Keep in mind that money isn't wealth, as it has no inherent value. Nothing has inherent value. But if money isn't wealth, then what the heck is? What's a wealthy person if not somebody rolling in dough? And I'm not talking about a guy who fell into the dough vat at Entemenn's and is trying to free himself. He's a goner and dough vats are death sentences.
Anyway, wealth is made up of actual things, and money is just used as an exchange medium to smooth the process along. Let's use a barter example. Farmer Brown wants to use a bag of grain from his farm to buy shoes for his horse from the blacksmith. What's really being traded is the "market value" of Farmer Brown's production, in this case a bag of grain. Now what if instead of the barter system we had money? Well, Farmer Brown would buy horse shoes with money instead. But what's really changed? He got that money by selling his grain. On a fundamental level, he's still using the market value of his production to buy things, only it's money, because having one standard thing that everybody accepts--and can be exchanged with and valued against other commodities--makes things work in case the local blacksmith is allergic to grain.
Or maybe it's you, using the money you earned from your job at McDonald's to buy socks. The labor you gave McDonald's resulted in a certain amount of production, which was worth a certain amount, which was your wage. Instead of buying socks with hamburgers and fast service though, you bought it with money. McDonald's gave you money for your production so you could trade the value of your production in at the store to get socks. Your purchasing power is proportional to the value of your production, ya see? That's what determines wages--productivity.
In these hypothetical exchanges, the actual wealth involved was grain and horse shoes in the first example, and fast food and service and socks in the second example. Money wasn't the wealth, it was just an exchange medium. This distinction is important to keep in mind because it leads to fallacies about economics. When you want to gauge a person's wealth, or a group of peoples' wealth, or a nation's wealth, you don't want to count their money--you want to see what things they actually own. It doesn't make sense to complain about the price of things going up if peoples' income is going up in proportion with rising prices--people still have the same purchasing power.
By the same token, if prices in general are falling (due to businesses becoming more efficient and not because of deflation--more on this later), it is the same effect as everybody having a higher income. In other words, when a Wal-Mart moves into your neighborhood, your income goes up. :-) This economic principle bothers the Wal-Mart haters of the world, but it makes for a great example.
Look around you, at the things in your house. Look at the computer you're reading this off of. All of that stuff is your wealth, not what's in your bank account. Remember this and economics will make more sense, especially when it comes to doohickeys like inflation, deflation, stagflation, claymation, and PlayStation.
Tuesday, November 6, 2007
Sunday, October 14, 2007
Money
Money. Dough. Bread. Mazoolah. Cha-ching. Greenbacks. The Green. Benjamins. Sweet Georgie Pea-Pod. Shim sham shadoobie. All of these are the names we give to money. Some were coined by me just now. Regardless of what we call it, money performs the same function. Why the heck do we have money, and what exactly is it? This is important, and I swear I'm not just coming up with filler material for my blog.
Without understanding money you can't really understand the economy, and since you work eight hours a day for the stuff, wouldn't you like to know what it is?
First, let's imagine an economy without money. It's not hard, because we used to have economies without money. They used the barter system. Bartering was when you exchanged stuff for other stuff. You might buy a meal at an inn with a big sack of grain, or use a dozen eggs to buy a new fork.
Imagine the complications this would lead to, since each barter exchange is negotiated on a one-to-one basis. For a shopkeeper to fix a certain amount of eggs as being worth a fork, or any other item, would be impractical if there happened to be an abundance of eggs. Suddenly his forks are all sold out and he's left holding huge bushels of eggs. He's eating omelets for a week, but after that some of his eggs will have gone bad. Maybe he could find enough buyers for all of his eggs in time, but it's a gamble, and he'll have to accept whatever the egg-buyers will take in trade.
You can't be sure what your goods will get you in trade, or that your goods will last long enough to be traded to somebody who has something you want. And what about big stuff? How many eggs does it take to buy a car? How many horse shoes does it take to buy a railroad? Land sakes, how many thimbles does it take to buy a space shuttle?!
And what about governments and businesses? How do they pay people? With beaver pelts? The ancient Roman government paid its soldiers in salt, or salarium as they called it, from which we get the word salary. So they were on the right track, they were sticking to one thing, and soldiers could plan their household budgets according to the amount of salt they expected. Salt had many uses. It could preserve meat, be sprinkled on food to heighten the tongue's sense of taste, and I guess that's it. All I can think of anyway. Doubtless Roman soldiers used the salt they didn't use around the house to barter with local shopkeepers, colosseum hot dog sellers, and any number of pomade outlets. I believe English soldiers were paid with beef, so this type of thing wasn't uncommon before blessed money was invented.
"Just a darn minute," you say. "I know they had money back then, they had gold coins and silver coins and stuff!"
That's true, they did. But not everybody did. Early money was based on precious metals (precious meaning "rare," not "aw, isn't that gold vein precious?"), and you carried around little pieces of the stuff with you that had been stamped with some emperor's mug on it. These were like the twenty or hundred dollar bills of their day, and most peasants carried around their salt, beef, chicken beaks, eggs, thimbles, and whatever else stood in for their dollars, quarters, nickels, and Sacajawea dollars.
Whether it was an actual good that had a use, or a precious metal (can't do much with them), both were mediums of exchange, like how CDs are a medium of music.
Eventually people discovered "credit," and that by "writings notes" of this "credit," you could travel from the place where the guy wrote the note, carrying this piece of "paper" which contained the "credit," to the place where the "credit" could be "redeemed" by somebody with gold. They were the early banks, and they gave the velvet rope industry a reason to exist. Although they didn't call themselves banks really, and instead of making people wait in line they just punched them in the head and instead of having inconvenient hours they just stabbed you in the chest. How I miss that system.
I'm kidding, of course, but this whole credit doo-hickey took the world by storm, and next thing you know people with lots of money are printing their own paper money, which was really just a less personalized and non-autographed version of the note of credit. Leaving aside the complications of different states with different money and different countries with their own money (I know, how crazy is that?), let's just say that eventually we Americans got to where we are today, with our dollar bill.
So up until the 1970s, instead of carrying around a huge store of goods with you when you went to the store (in case they don't want any eggs in exchange for their matches), you could hand them dollars, for which they could go and exchange with a federal bank for a dollar's worth of gold. In effect, each dollar was a note of credit saying "IOU a dollar's worth of gold."
Then they took us off the gold standard, so currency wasn't worth a certain amount of gold any more. Gold standards are sort of impractical these days. So now, instead of dollars being a little note of credit saying "IOU one dollar worth of gold" they are.....well, what the heck are they worth now? What makes money valuable if it's not worth gold?
Let me change your thinking here: what made gold valuable in the first place? Certainly not its uses, since they were limited. Jewelry alone can't account for the high value placed on gold. The value of gold is the same as the value of paper money--it is valuable because people are willing to accept it for trade. Why are they willing to accept it? Because they expect others to accept it also.
THIS IS KEY.
Nothing has "inherent value." Gold itself isn't valuable without somebody placing value on it, and its value as money (i.e. an exchange medium) derives from the expectation that others will put value on it as well. Money is the same way. It's just printed paper. It's value comes from our expectation that we can buy things with it. The real value of money is what can be bought with it, not the money itself. Once you start thinking of money as a paper representation of actual goods and services, you understand money better and you understand the economy better.
Gold was durable, scarce, and others valued it as an exchange medium, which made it good as money for its time. But it's impractical today because it is heavy, not easily divisible, and I frankly don't like the idea of my country's money supply being partly tied up in peoples' necklaces. Control of the money supply is important to prevent monetary problems, and having paper money makes that easy. Paper money is pretty tough (for paper), is hard to duplicate (making it scarce), and others see a lot of value in it. Paper money is what's called "fiat money," meaning it has value by government fiat, or command. The government says "this is money" and if we don't expect the government to fall then we can rely on it.
Fiat money is worthless if nobody accepts it, such as when Iraq was invaded in 2003. There were pictures in the media of Iraqis cheerfully burning their Iraqi money with Saddam's picture on it, because his government was no more. That is the main weakness of fiat money, but I still like the system (easy for me to say, in this country). Some countries actually tie their currency into the US dollar, the way we used to tie ours into gold.
The big weakness of gold, apart from the ones I already mentioned, is that when they invent replicators like on Star Trek, elements like gold will be easy to replicate, making gold abundant and worth a lot less. Hey, it'll happen!
Without understanding money you can't really understand the economy, and since you work eight hours a day for the stuff, wouldn't you like to know what it is?
First, let's imagine an economy without money. It's not hard, because we used to have economies without money. They used the barter system. Bartering was when you exchanged stuff for other stuff. You might buy a meal at an inn with a big sack of grain, or use a dozen eggs to buy a new fork.
Imagine the complications this would lead to, since each barter exchange is negotiated on a one-to-one basis. For a shopkeeper to fix a certain amount of eggs as being worth a fork, or any other item, would be impractical if there happened to be an abundance of eggs. Suddenly his forks are all sold out and he's left holding huge bushels of eggs. He's eating omelets for a week, but after that some of his eggs will have gone bad. Maybe he could find enough buyers for all of his eggs in time, but it's a gamble, and he'll have to accept whatever the egg-buyers will take in trade.
You can't be sure what your goods will get you in trade, or that your goods will last long enough to be traded to somebody who has something you want. And what about big stuff? How many eggs does it take to buy a car? How many horse shoes does it take to buy a railroad? Land sakes, how many thimbles does it take to buy a space shuttle?!
And what about governments and businesses? How do they pay people? With beaver pelts? The ancient Roman government paid its soldiers in salt, or salarium as they called it, from which we get the word salary. So they were on the right track, they were sticking to one thing, and soldiers could plan their household budgets according to the amount of salt they expected. Salt had many uses. It could preserve meat, be sprinkled on food to heighten the tongue's sense of taste, and I guess that's it. All I can think of anyway. Doubtless Roman soldiers used the salt they didn't use around the house to barter with local shopkeepers, colosseum hot dog sellers, and any number of pomade outlets. I believe English soldiers were paid with beef, so this type of thing wasn't uncommon before blessed money was invented.
"Just a darn minute," you say. "I know they had money back then, they had gold coins and silver coins and stuff!"
That's true, they did. But not everybody did. Early money was based on precious metals (precious meaning "rare," not "aw, isn't that gold vein precious?"), and you carried around little pieces of the stuff with you that had been stamped with some emperor's mug on it. These were like the twenty or hundred dollar bills of their day, and most peasants carried around their salt, beef, chicken beaks, eggs, thimbles, and whatever else stood in for their dollars, quarters, nickels, and Sacajawea dollars.
Whether it was an actual good that had a use, or a precious metal (can't do much with them), both were mediums of exchange, like how CDs are a medium of music.
Eventually people discovered "credit," and that by "writings notes" of this "credit," you could travel from the place where the guy wrote the note, carrying this piece of "paper" which contained the "credit," to the place where the "credit" could be "redeemed" by somebody with gold. They were the early banks, and they gave the velvet rope industry a reason to exist. Although they didn't call themselves banks really, and instead of making people wait in line they just punched them in the head and instead of having inconvenient hours they just stabbed you in the chest. How I miss that system.
I'm kidding, of course, but this whole credit doo-hickey took the world by storm, and next thing you know people with lots of money are printing their own paper money, which was really just a less personalized and non-autographed version of the note of credit. Leaving aside the complications of different states with different money and different countries with their own money (I know, how crazy is that?), let's just say that eventually we Americans got to where we are today, with our dollar bill.
So up until the 1970s, instead of carrying around a huge store of goods with you when you went to the store (in case they don't want any eggs in exchange for their matches), you could hand them dollars, for which they could go and exchange with a federal bank for a dollar's worth of gold. In effect, each dollar was a note of credit saying "IOU a dollar's worth of gold."
Then they took us off the gold standard, so currency wasn't worth a certain amount of gold any more. Gold standards are sort of impractical these days. So now, instead of dollars being a little note of credit saying "IOU one dollar worth of gold" they are.....well, what the heck are they worth now? What makes money valuable if it's not worth gold?
Let me change your thinking here: what made gold valuable in the first place? Certainly not its uses, since they were limited. Jewelry alone can't account for the high value placed on gold. The value of gold is the same as the value of paper money--it is valuable because people are willing to accept it for trade. Why are they willing to accept it? Because they expect others to accept it also.
THIS IS KEY.
Nothing has "inherent value." Gold itself isn't valuable without somebody placing value on it, and its value as money (i.e. an exchange medium) derives from the expectation that others will put value on it as well. Money is the same way. It's just printed paper. It's value comes from our expectation that we can buy things with it. The real value of money is what can be bought with it, not the money itself. Once you start thinking of money as a paper representation of actual goods and services, you understand money better and you understand the economy better.
Gold was durable, scarce, and others valued it as an exchange medium, which made it good as money for its time. But it's impractical today because it is heavy, not easily divisible, and I frankly don't like the idea of my country's money supply being partly tied up in peoples' necklaces. Control of the money supply is important to prevent monetary problems, and having paper money makes that easy. Paper money is pretty tough (for paper), is hard to duplicate (making it scarce), and others see a lot of value in it. Paper money is what's called "fiat money," meaning it has value by government fiat, or command. The government says "this is money" and if we don't expect the government to fall then we can rely on it.
Fiat money is worthless if nobody accepts it, such as when Iraq was invaded in 2003. There were pictures in the media of Iraqis cheerfully burning their Iraqi money with Saddam's picture on it, because his government was no more. That is the main weakness of fiat money, but I still like the system (easy for me to say, in this country). Some countries actually tie their currency into the US dollar, the way we used to tie ours into gold.
The big weakness of gold, apart from the ones I already mentioned, is that when they invent replicators like on Star Trek, elements like gold will be easy to replicate, making gold abundant and worth a lot less. Hey, it'll happen!
Sunday, October 7, 2007
Introduction and the First Lesson: Incentives Matter
Hi everybody. This is the first post on my new blog about economics. People have told me I should have a radio show, or lobby Congress or the President, or run for office myself. So I did the next, most effective thing which will doubtlessly reach millions of people overnight--I started a blog.
Throughout this blog you will see me use humor on occasion, or what I call humor, but it doesn't mean that what I say is not to be taken seriously. Which is to say that what I say should be taken seriously, even if I use humor. Which is a roundabout way of mentioning the seriousness of not saying what I'm thinking when I use humor. Or something.
Before I get into today's lesson, I'd like to explain what economics is and why it is so darn important. A quick definition taken from some other economist who probably won the Nobel Prize or something:
Economics is the study of the allocation of scarce resources which have alternative uses.
"What? I thought economics was about money. Or business. Or something."
Nope, economics does not necessarily concern itself with money, or markets, or businesses, or government, or stocks, or banks, or any of the other things you may immediately think of when you hear the term "economics."
Now a resource is a thing which can be used as an input into a process to get a certain output. Like putting gasoline into a car. The resource is gas, the output is an engine that runs. Some important points to note here, which explain how gasoline is an economics thing, is that 1) gasoline has other uses and 2) gasoline is scarce.
Think about it. If a certain resource were infinite, what need would there be to economize? We'd all have enough. Demand would be satisfied everywhere. But resources are scarce. Breathable air is scarce, oil is scarce, healthcare is scarce, education is scarce, food is scarce, DVD players are scarce. Just because something is in abundance doesn't mean it's not scarce. Scarce means "less than infinite," or "finite" in other words. Part of the problem of economics is getting a limited resource to the largest number of people, or satisfying as much demand for that resource as possible.
And gasoline can be used for other things. It can be used to fuel other peoples' cars instead of your own, or it can be used in lawn mowers, or for entertainers to set their farts on fire. Gasoline isn't the only resource with alternative uses. Wood, steel, plastic, time, space, and even human beings themselves have alternative uses. Another part of the problem of economics is putting resources to their most valued use first, rather than putting them to a use that isn't as valued.
So, now you see how economics is not just about money, or markets, or things of a financial nature. It is about any scarce resource that has alternative uses, and how it can be allocated.
Why is this important? Don't we elect politicians so we don't have to worry about this kind of thing? Shouldn't we leave this to the experts? Yes and no. Some things belong in the hands of politicians because politicians are best able to handle those particular things, but a great many things are best left to people to decide. I don't say this because of some political ideology or philosophical notion of rights, but simply because it's more economical. You'll understand more as this blog goes on.
Back to why economics is important: Because people starve to death. Governments have committed genocide and gone to war. People go without the health care they need to survive or the education they need to get a job or the basic necessities they need to get by. Because single mothers don't make enough to raise a family. All from bad economic policies put into place, or economic problems ignored or exacerbated by the government.
Economics is not, and should not, be the concern only of rich people living comfortable lives, because when bad economics is put into action the people on the margin are the ones who suffer first, and who suffer the worst. An inadequate education system is much harder on a single mother than on a Senator's son who will wind up in an Ivy League university. Rampant inflation is far worse for blue collar workers living paycheck to paycheck than it is on the CEO of Viacom. (which is not to say that all business owners are rich, most of them are not and many of them make less money than those they employ)
LESSON ONE
I hope you're not too bored, and you're still with me, because now that I have my intro out of the way I can start the first lesson. And since you were nice enough to read this far (you didn't skip ahead, did you?) I'll make it as brief as possible. Here's the lesson: incentives matter. Corollary: so do constraints.
I should probably add a little meat to those bones, huh? What is an incentive? It's a thing that leads people to do...things. For instance, the incentive to avoid starvation will make you eat food. The incentive to avoid being killed will make you not run with the bulls in Pamplona. The incentive to have a higher material standard of living will make you go for a job that pays more money, even if you're already quite comfortable where you are. That one incentive is the incentive from which most other incentives flow--that is, the incentives that matter in economics--because it is the incentive to make ourselves better off (meaning having a higher material standard of living) which drives the economy. It's how enough food is brought into cities to feed a million people a day, it's how gas is brought to the gas station, it's how drugs are invented. Somebody followed their incentive to engage in a trade that made themselves better off. And as a side effect, it made somebody else better off too.
You worked for your boss. He got your production (whether you produce cars, insurance, or just mopped floors, it's the same principle), and you got his money. Your incentives were coordinated so that you each were better off. You valued the wage more than the time and effort it took to earn it, and he valued your output more than the money he paid you for it. Without incentives, nobody would go to work, eat, sleep, poop, or bring food to grocery stores.
If all of this seems stupidly simple, and a waste of time to even cover, then consider that many very intelligent, educated, and powerful people have put into place economic policies which totally ignore the importance of incentives. The Soviet Union, for instance, was a country that existed many moons ago. From 1917 to 1991, if memory serves me right. The economy was wholly owned and controlled by the government under a system called "communism," and there was no such thing as privately owned property. Everybody worked to support everybody else, not for themselves. Really. By removing the profit motive (a very important incentive in economics) nobody really felt like doing work. The only incentives that existed under this system were the incentive to avoid starvation, jail time, or execution. Over time the Soviet authorities realized they needed to provide incentives to get people to do things, so they started giving better apartments and things like refrigerators and tvs to their top performers.
Basically, millions of people in the Soviet Union wound up starving to death, and those that lived through the whole thing lived in horrible poverty. It was a country that could put a man into space but couldn't feed its people. This isn't to harp on the Soviet Union (I am a Russophile, after all), merely their economic system.
That was just one really horrendous and obvious example of how incentives matter. There are other policies or economic systems which also ignore incentives, but few if any are as bad as communism was (and still is, in countries like Cuba and North Korea), so it's great to use as a clear example. Starvation drives the point home better than do higher costs for sugar, doncha know.
"Didn't he say something about constraints?"
Yes I did, and this will be quick. Well, I'll try to make it quick. Constraints are the opposite of incentives. Incentives lead us toward something (earning more money, eating, going to work, buying things) and constraints drive us away from things. An example is how the higher tax on gasoline (currently 46 cents per gallon I think) adds to the price of gasoline, making us buy less gas and drive less than we would if the tax on gasoline were just a normal sales tax. Basically, incentives lead us to things that would make us gain, while constraints drive us away from things that would make us lose.
This isn't to say that constraints are worse than incentives, they are just different. I, personally, prefer a system of laws where there are constraints in place that keep guys with pantyhose on their heads from breaking into my apartment and stealing my HD DVD player ($233 at Amazon with free shipping, you can't beat that). A penalty for something is a constraint, and jail time or having your balls tased by a rookie cop counts as a penalty. It would make that panty-headed guy lose. He'd lose his time and his freedom, both of which are of value to him because he could use those resources to gain. Either with a job, finding coins on the street, or just walking through a park and enjoying the day.
Boy, I haven't talked about scarce resources with alternative uses and how they can be allocated much, have I? Never fear, I just wanted to set the groundwork by talking about the most fundamental thing in economics, the importance of incentives and constraints, since they are what guide human behavior and without human behavior, an economic model is just a plan.
Until next time..........
Throughout this blog you will see me use humor on occasion, or what I call humor, but it doesn't mean that what I say is not to be taken seriously. Which is to say that what I say should be taken seriously, even if I use humor. Which is a roundabout way of mentioning the seriousness of not saying what I'm thinking when I use humor. Or something.
Before I get into today's lesson, I'd like to explain what economics is and why it is so darn important. A quick definition taken from some other economist who probably won the Nobel Prize or something:
Economics is the study of the allocation of scarce resources which have alternative uses.
"What? I thought economics was about money. Or business. Or something."
Nope, economics does not necessarily concern itself with money, or markets, or businesses, or government, or stocks, or banks, or any of the other things you may immediately think of when you hear the term "economics."
Now a resource is a thing which can be used as an input into a process to get a certain output. Like putting gasoline into a car. The resource is gas, the output is an engine that runs. Some important points to note here, which explain how gasoline is an economics thing, is that 1) gasoline has other uses and 2) gasoline is scarce.
Think about it. If a certain resource were infinite, what need would there be to economize? We'd all have enough. Demand would be satisfied everywhere. But resources are scarce. Breathable air is scarce, oil is scarce, healthcare is scarce, education is scarce, food is scarce, DVD players are scarce. Just because something is in abundance doesn't mean it's not scarce. Scarce means "less than infinite," or "finite" in other words. Part of the problem of economics is getting a limited resource to the largest number of people, or satisfying as much demand for that resource as possible.
And gasoline can be used for other things. It can be used to fuel other peoples' cars instead of your own, or it can be used in lawn mowers, or for entertainers to set their farts on fire. Gasoline isn't the only resource with alternative uses. Wood, steel, plastic, time, space, and even human beings themselves have alternative uses. Another part of the problem of economics is putting resources to their most valued use first, rather than putting them to a use that isn't as valued.
So, now you see how economics is not just about money, or markets, or things of a financial nature. It is about any scarce resource that has alternative uses, and how it can be allocated.
Why is this important? Don't we elect politicians so we don't have to worry about this kind of thing? Shouldn't we leave this to the experts? Yes and no. Some things belong in the hands of politicians because politicians are best able to handle those particular things, but a great many things are best left to people to decide. I don't say this because of some political ideology or philosophical notion of rights, but simply because it's more economical. You'll understand more as this blog goes on.
Back to why economics is important: Because people starve to death. Governments have committed genocide and gone to war. People go without the health care they need to survive or the education they need to get a job or the basic necessities they need to get by. Because single mothers don't make enough to raise a family. All from bad economic policies put into place, or economic problems ignored or exacerbated by the government.
Economics is not, and should not, be the concern only of rich people living comfortable lives, because when bad economics is put into action the people on the margin are the ones who suffer first, and who suffer the worst. An inadequate education system is much harder on a single mother than on a Senator's son who will wind up in an Ivy League university. Rampant inflation is far worse for blue collar workers living paycheck to paycheck than it is on the CEO of Viacom. (which is not to say that all business owners are rich, most of them are not and many of them make less money than those they employ)
LESSON ONE
I hope you're not too bored, and you're still with me, because now that I have my intro out of the way I can start the first lesson. And since you were nice enough to read this far (you didn't skip ahead, did you?) I'll make it as brief as possible. Here's the lesson: incentives matter. Corollary: so do constraints.
I should probably add a little meat to those bones, huh? What is an incentive? It's a thing that leads people to do...things. For instance, the incentive to avoid starvation will make you eat food. The incentive to avoid being killed will make you not run with the bulls in Pamplona. The incentive to have a higher material standard of living will make you go for a job that pays more money, even if you're already quite comfortable where you are. That one incentive is the incentive from which most other incentives flow--that is, the incentives that matter in economics--because it is the incentive to make ourselves better off (meaning having a higher material standard of living) which drives the economy. It's how enough food is brought into cities to feed a million people a day, it's how gas is brought to the gas station, it's how drugs are invented. Somebody followed their incentive to engage in a trade that made themselves better off. And as a side effect, it made somebody else better off too.
You worked for your boss. He got your production (whether you produce cars, insurance, or just mopped floors, it's the same principle), and you got his money. Your incentives were coordinated so that you each were better off. You valued the wage more than the time and effort it took to earn it, and he valued your output more than the money he paid you for it. Without incentives, nobody would go to work, eat, sleep, poop, or bring food to grocery stores.
If all of this seems stupidly simple, and a waste of time to even cover, then consider that many very intelligent, educated, and powerful people have put into place economic policies which totally ignore the importance of incentives. The Soviet Union, for instance, was a country that existed many moons ago. From 1917 to 1991, if memory serves me right. The economy was wholly owned and controlled by the government under a system called "communism," and there was no such thing as privately owned property. Everybody worked to support everybody else, not for themselves. Really. By removing the profit motive (a very important incentive in economics) nobody really felt like doing work. The only incentives that existed under this system were the incentive to avoid starvation, jail time, or execution. Over time the Soviet authorities realized they needed to provide incentives to get people to do things, so they started giving better apartments and things like refrigerators and tvs to their top performers.
Basically, millions of people in the Soviet Union wound up starving to death, and those that lived through the whole thing lived in horrible poverty. It was a country that could put a man into space but couldn't feed its people. This isn't to harp on the Soviet Union (I am a Russophile, after all), merely their economic system.
That was just one really horrendous and obvious example of how incentives matter. There are other policies or economic systems which also ignore incentives, but few if any are as bad as communism was (and still is, in countries like Cuba and North Korea), so it's great to use as a clear example. Starvation drives the point home better than do higher costs for sugar, doncha know.
"Didn't he say something about constraints?"
Yes I did, and this will be quick. Well, I'll try to make it quick. Constraints are the opposite of incentives. Incentives lead us toward something (earning more money, eating, going to work, buying things) and constraints drive us away from things. An example is how the higher tax on gasoline (currently 46 cents per gallon I think) adds to the price of gasoline, making us buy less gas and drive less than we would if the tax on gasoline were just a normal sales tax. Basically, incentives lead us to things that would make us gain, while constraints drive us away from things that would make us lose.
This isn't to say that constraints are worse than incentives, they are just different. I, personally, prefer a system of laws where there are constraints in place that keep guys with pantyhose on their heads from breaking into my apartment and stealing my HD DVD player ($233 at Amazon with free shipping, you can't beat that). A penalty for something is a constraint, and jail time or having your balls tased by a rookie cop counts as a penalty. It would make that panty-headed guy lose. He'd lose his time and his freedom, both of which are of value to him because he could use those resources to gain. Either with a job, finding coins on the street, or just walking through a park and enjoying the day.
Boy, I haven't talked about scarce resources with alternative uses and how they can be allocated much, have I? Never fear, I just wanted to set the groundwork by talking about the most fundamental thing in economics, the importance of incentives and constraints, since they are what guide human behavior and without human behavior, an economic model is just a plan.
Until next time..........
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