How_Money_Works_-_The_Facts_Visually_Explained

How it works

With the massive expansion of trade that accompanied

the discovery of the Americas and the growth of

nation states in Europe in the 16th and 17th centuries,

individuals began to think in more detail about the

idea of economics. They variously suggested that

controlling the level of imports (mercantilism), trading

only in the goods a country made best (comparative

advantage), or choosing not to intervene in the markets

(laissez-faire) might improve their people’s economic

well-being. In the 18th century, economist Adam Smith

proposed that government intervention—controlling

wages and prices—was unnecessary because the

self-interested decisions of individuals, who all want

to be better off, cumulatively ensure the prosperity

of their society as a whole. In addition, he believed that

in a freely competitive market, the impetus to make

profit ensures that goods are valued at a fair price.

By the 18th century, people began to study the economy more closely, as thinkers

tried to understand how the trade and investment decisions of individuals could

have an effect on prices and wages throughout a country.

Adam Smith’s

“invisible hand”

In his book The Wealth of Nations

(1776), the Scottish economist Adam

Smith suggested that the sum of the

decisions made by individuals, each

of whom wanting to be better off,

results in a country becoming more

prosperous without those individuals

ever having consciously desired that

end. According to Adam Smith, where

there is demand for goods, sellers will

enter the market. In the pursuit of

profit they will increase the production

of these goods, supporting industry.

Furthermore in a competitive

market, a seller’s self-interest limits the

price rises they can demand in that if

they charge too much, buyers will

stop purchasing their goods or lose

sales to competitors willing to charge

less. This can have a deflationary

effect on prices and ensures that the

economy remains in balance. Smith

referred to this market mechanism,

which turns individual self-interest

into wider economic prosperity, as an

“invisible hand” guiding the economy.

Seller A is charging too much

for his goods but still makes sales

because he is the only seller and

enjoys an effective monopoly.

SELLER B

$4 $2

Seller B sees an opportunity to

enter the market and sets up her

own stall, selling at a lower price

in order to undercut A.

SELLER A

Emergence of modern

economics

Buyers reduce their

purchases as prices are

prohibitively high.

BUYER

As Seller B’s price is lower,

buyers begin to buy from her

instead of Seller A.

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US_020-021_Basic_Principles_of_Economics.indd 20 13/10/2016 16:15