This chapter will focus on the economic systems of our society and therefore the economy of the real world.
This chapter will offer a general understanding of how entities interact with each other in an economic environment and will later be used to compare real-world economic systems to the economic systems of games. This chapter will also be used during the next chapters to point out what different approaches a virtual economy offers and what problems are created by current in-game economies.
1.1. Objects of basic economics
1.1.1. Goods and services
Economic entities focus on the creation and/or consumption of products. These products are described as goods and services. Goods are considered all of these products that can be defined as physical objects, while services are defined as tasks that are completed for other economic entities without the necessity to exchange physical objects. An example of this would be transportation.
1.1.2. Economic entities
Economic entities are entities that heavily affect and are affected by the economy. Examples of this are: Firms, individuals, governments, banking systems, and insurance companies.
It should also be noted that an economic entity is explained in the way a legal entity functions while a legal entity itself simply proves that it exists. (Andrei, 2013, p. 240)
1.1.3. The economic system:
The economic system is a large set of interrelated production and consumption activities based on which economic entities decide how resources should be allocated. (Andrei, 2013, p. 13)
1.2. The definition of economies
“Economy defines itself as an entire network of producers, distributors and consumers of goods and services in a local, regional or national community.” (Business Dictionary, Definition Economy, n.d.)
Based on this it can be said that an economy is a set of related production and consumption activities based on which economic entities decide how resources should be allocated. This is also known as an economic system. (Investopedia, Economy, n.d.)
This means, that an economy defines all activity related to the production, consumption, and trade of goods and services in an area. An economy applies to everyone from individuals to entities such as corporations and governments. The economy of a certain area or country changes based on its culture, laws, history, geography and other factors. It adapts out of necessity. Due to this development, it can be determined that most if not all economic systems differ from each other.7 In economies producers and distributors exchange goods and services with consumers. In addition to that economies can be divided into sub-areas based on location or related services. These areas do also exist within the view of all economic systems and can be viewed independently and in relation to the other market participants. It is important to note that all economic systems interact with each other unless they are completely divided by location, politic, religion or another force that is able to isolate all forms of interaction between whole economic systems.
1.3. Micro- & Macro-economics
The overall difference between micro- and macro-economics is that microeconomics focuses on individual economic entities, while macro-economics study an economic system of national or federal economic scale, a large system formed by a number of different microeconomic entities. (Andrei, 2013, p. 240)
Considering this structure and the relation between micro- and macro-economics it becomes possible to understand the effects that micro-economics have on a macro-economic level. These pieces of information can be utilized to develop an understanding of what aspects or events in a society result in which economic development and therefore allow to evaluate if these events, political changes, ethical changes or other influencing factors have a positive or negative effect on the desired market situation.
This also works in reverse, by evaluating the changes within the development of an economy. This can be done by studying the effect that micro- & macro-economics have on politic, ethics, income or other influencing factors. This makes it possible to determine, what can be considered positive or negative depending on whatever the authority behind an economic system considers desirable.
1.4. Goals of economies
The goal of most economies is the creation of a system that allows different economic entities to interact with each other in a profitable way, to supply all consumers with the goods and services they need or want and by extension to increase economic growth.
This goal is defined by the five main goals economies try to achieve: full employment, stability, economic growth, efficiency, and equity. (AmosWEB Encyclonomic, n.d.)
Efficiency is considered to be a microeconomic goal, which tries to fulfil the needs of a society to the best possible level with the resources available. This is best executed when limited resources are allocated in a way that fulfils as many needs and wants of a society as possible.9
Equity is also a micro-economic goal and concerns itself with the ‘fair’ distribution of income and wealth. While it is a common view that wealth should be ‘fairly’ distributed, the definitions of a ‘fair’ distribution vary. The three main approaches are the goal of everyone having the same income and wealth, the distribution of income and wealth based on production value and the income and wealth based on needs. (AmosWEB Encyclonomic, n.d.)
Full Employment is a macro-economic goal, with the objective of utilizing all available resources labour, capital, land, and entrepreneurship to produce goods and services. (AmosWEB Encyclonomic, n.d.)
Stability is a macroeconomic goal that is achieved if changes in production, employment and prices are avoided or limited. It is usually rated based on month-to-month or year-to-year changes and helps consumers and other economic entities to make long-term assumptions and to plan their finances accordingly. (AmosWEB Encyclonomic, n.d.)
Economic Growth counts as a macro-economic goal and focuses on the ability of an economy to produce more goods and services over a duration of time. This means that if more goods and services are produced in one year compared to the last year economic growth is achieved. This usually results in improved living standards and less scarcity of goods and services. (AmosWEB Encyclonomic, n.d.)
While the five goals of mixed economies are widely considered to be desirable, trying to achieve one goal often works against the objective of the others. An example of this could be: “Full Employment and Stability: The Central Bank of Northwest Queoldiolia seeks to promote lower rates of unemployment through expansionary monetary policy. The economy expands, unemployment falls, and full employment is achieved, but inflation emerges from the over-stimulated economy.” (AmosWEB Encyclonomic, n.d.)
In addition to the goals of mixed economies, it is also quite common that economies have more specific goals related to a country or government. Examples of this could be: Solving environmental issues, upgrading the infrastructure, optimization of the utilized landscape, etc.
1.5. The definition of supply and demand
“Demand defines as a quantity of one individual good (service) that an individual, group or economic entity wishes and is able to acquire (purchase) within a considered period of time.” (Andrei, 2013, p. 150)
Demand can be divided into two main areas: Individual demand, which focuses on the goods and services a single individual wishes to acquire, and market demand, which includes the demands of all economic entities within a market area.
It should be noted that the expected behaviour of the individual demand versus the market demand is, that the individual demand mainly follows the market demand, but can differ for some goods or services. This makes the individual demand more focused on specific people and allows to conclude tests for certain groups of economic entities for example depending on education, income or location.
“Supply is the total amount of a good or service available for purchase at any specified price.” (Business Dictionary, Definition Supply, n.d.)
Supply determines:
Price of a good or service:
The current owner or distributor of a good or service will try to achieve the highest possible price for that good or service, while the consumer will try to obtain it at the lowest price. This means that the actual price will be based on the highest price a consumer is willing to pay and the lowest price for which that good or service is available in one economy.
Production cost of a good or service:
If the supply of a good or service is high it is likely that the production process will be improved, which reduces the production costs and increases profit.
Competition between economic entities:
Over time competition will result in lower prices for that good or service since more economic entities can compete with each other. Competing for goods and services will reduce the price and a supplier may switch to more profitable products, therefore, reducing the supply of the previous good or service.
1.6. The market
“The market is an actual or nominal place where forces of demand and supply operate, and where buyers and sellers interact (directly or through intermediaries) to trade goods, services, or contracts or instruments, for money or barter.
Markets include mechanisms or means for determining the price of the traded item, communicating the price information, facilitating deals and transactions, and affecting distribution. The market for a particular item is made up of existing and potential customers who need it and have the ability and willingness to pay for it.” (Business Dictionary, Definition Market, n.d.)
Based on this definition it can be said that the market is a system based on the interest of potential customers and therefore demand. The prices are based on how many potential customers are willing to pay and are therefore based on supply and demand. This makes this system one that is focused on the mutual interest of both the consumers as well as the distributors and by extension of that also of the producers.
This pushes this system into a position, in which the three parties consumer, distributor, and producer have to come to an agreement about how much a good or service should cost.
This situation allows for conflict between all parties that eventually resolves at a ‘fair’ price. This price is based on the amount of currency a customer is willing to invest into a good or a service and how much of a good or service a distributor has to sell to justify the production of a given good or service. These prices are then further influenced by many factors like prestige and necessity.
Another factor is how much supply and demand differ from each other. If there is more supply than demand the costs of a given good or service will fall since there will be more competition between different distributors for a smaller number of customers. If the demand for a given good or service is greater than the supply, the costs of that good or service will rise, since there is only a limited amount of that good or service and not every consumer is able to obtain it. This results in a race to obtain the given good or service between all the different consumers who want or need it and have the ability and willingness to pay for it.
1.7. Planned economies
“Planned economies or command-based economies are systems where the government, rather than the free market, determines what goods should be produced, how much should be produced and the price at which the goods are offered for sale. It also determines investments and incomes.” (Investopedia, Command Economy, n.d.)
This means that the government removes all competition between distributors by controlling all business-relevant factors like production rate and the price of any good or service. This allows a nation to focus its economy on national economic goals at any given point of time. An example of this would be if a nation wants to achieve economic growth.
These economic systems often feature government-owned monopoly business sectors, which are necessary to meet the goals of the national economy. This results in an avoidance of competition in those business sectors. Examples of these businesses usually include financial institutions or utility companies. (Investopedia, Command Economy, n.d.)
The most known problem with this form of economy is the lack of knowledge the central planner can have since it is almost impossible to predict how much of a product must be produced and how the demand for every product will shape out. The central planner has to adjust the supply to the predictions made for these factors. Another common problem is the necessity of a constantly changing system. The central planner needs to adjust the economic system constantly to meet the goals of the government and all changes need to be communicated to the companies and can only then be realized. This limits this approach to a limited amount of changes for the economic systems over long periods of time. This is, because of the time needed to communicate and realize these changes. Resulting in a system that has difficulties with fixing the problems of the previous adjustments for a longer period of time.
1.8. The differences between Market- and Command-Based economies
Market- and command-based economies are the most common forms of economy in our society.
1.8.1. Market-based economies
“Market-based economies allow goods to flow freely through the market, according to supply and demand. This type of economy has a tendency to naturally balance itself. As the prices in one sector for an industry rise due to demand, the money and labour necessary to fill that demand filter to the places where they are needed.” (Investopedia, Economy, n.d.)
Based on this, it is possible to determine those market-based economies create a positive feedback loop (Salen & Zimmerman, 2004, p. Chapter 18) for the production process, in which based on the demand for a good or service more jobs and tools will be created to speed up the production process. This allows to sell more of a good or a service, which in return allows spending more on jobs and the development and creation of tools. This automatically stops or declines if the supply of a good or service is equal to the market demand or if the market demand falls below the available supply of a good or service. This opens up space for new demands in the market structure and labour and financial resources are then redirected towards fulfilling these new demands.
1.8.2. Command-based economies
“Command-based economies are dependent on a central political agent, which controls the price and distribution of goods. Supply and demand cannot play out naturally in this system because it is centrally planned, so imbalances are common.” (Investopedia, Economy, n.d.)
In command-based economies feedback (Salen & Zimmerman, 2004, p. Chapter 18) has no effect on the market. This can easily result in problems with money and product distribution. Since it is possible that a good or a service, which is needed by many can only be obtained by a small amount of the population because the set price is too expensive for the others. It also has the tendency of creating a good or service in too low quantities. Pushing a come first get first system, depending on the way it is managed can result in high waiting periods for obtaining specific goods or services. But the opposite can also be the case: If a good or service is too cheap or too much of a good or service is produced, a large quantity of that good or in the case of services time, will be wasted either by the consumer or the producer. It should still be noted that with near-perfect insight and short adjustment periods for changes (which can’t consistently be obtained in the real world but is possible in virtual environments), prices and quantities could be controlled in a way that could allow command-based economies to function.
1.8.3. Comparison between both systems
Viewing these two concepts in direct comparison it becomes possible to see that one of the main differences between these two forms of handling economic systems is that market-based economies directly respond to the feedback of the consumers and distributors, while command-based economies won’t. This allows market-based economies to automatically readjust themselves, while command-based economies need to be adjusted manually.
That being said, it should also be noted, that properly managed command-based economies have the ability to distribute more resources to goods and services that consumers need rather than goods and services that consumers want allowing for a more optimized flow of resources since this can be planned in advance. Command-based economies allow theoretically guarantee that companies can keep producing since resource supply is guaranteed before the production starts. (Investopedia, Command Economy, n.d.)
1.9. Definition of inflation
“Inflation is a quantitative measure of the rate at which the average price level of a basket of selected goods and services in an economy increases over a period of time. Often expressed as a percentage, inflation indicates a decrease in the purchasing power of a nation’s currency. As prices rise, they start to impact the general cost of living for the common public and the appropriate monetary authority of the country, like the central bank, then takes the necessary measures to keep inflation within permissible limits and keep the economy running smoothly. Inflation is measured in a variety of ways depending upon the types of goods and services considered, and is the opposite of deflation which indicates a general decline occurring in prices for goods and services when the inflation rate falls below 0 percent.” (Investopedia, Inflation, n.d.)
This means that inflation is defined by the rising amount of currency needed to obtain a good or service over a certain amount of time. So basically if someone would have 10$ and it would be possible to obtain 10 eggs for that amount of money, but that person saves the money and wants to buy eggs 10 years later, but now one egg costs 2$ and that person can only obtain 5 eggs with the 10$ that he or she saved.
The inverted effect of this resolves in a reduced amount of currency needed to obtain a good or service which is called deflation.
The causes of inflation can be divided into three main types: “Demand-pull inflation, cost-push inflation, and built-in inflation” (Investopedia, Inflation, n.d.), which causes inflation in one or more of the following ways.
Demand-pull inflation:
This form of inflation happens if the demand for a good or service rises faster than the possibility to supply that good or service. Resulting in higher prices for that good or service. Another way this form of inflation can happen is if the total amount of currency increases since this forces a good or service to increase its costs to allow it to keep its value. (Investopedia, Inflation, n.d.)
Cost-pull inflation:
This form of inflation is based on increased production costs, be it the increased costs of labour or resources. These higher production costs must be converted into a higher price for a good or service to allow it to keep its value. (Investopedia, Inflation, n.d.)
Built-in inflation:
In this case inflation itself pushes inflation. If goods and services become more expensive the labour force needs more wages, which results in the necessity of a higher cost for a good or service as explained in ‘Cost-pull inflation’. (Investopedia, Inflation, n.d.)
1.10. A brief overview of the history of the economy
The Greek meaning of the world economy is household management. The first recorded times of economics as an area of study were by the philosophers in ancient Greece, but the way economics are studied today has its roots in the 18th century in Scotland and France.
At first, studying how people work together and use resources for the production of goods and services was named political economy, and the people who studied this area were called political philosophers. (Investopedia, Economy, n.d.)
The Scottish philosopher Adam Smith, wrote 1776 the famous economic treatise “The Wealth of Nations”. He believed that economies come from the pre-historic bartering systems to money and eventually to credit-based economies. (Investopedia, Economy, n.d.)
“During the 19th century, technology and the growth of international trade created stronger ties among countries, a process that accelerated into the Great Depression and World War II. After 50 years of the Cold War and the end of the Bretton Woods agreement, the late 20th and early 21st centuries saw renewed globalization of economies.” (Investopedia, Economy, n.d.)
1.11. The math behind economics
Almost all economic revelations can be translated into mathematical formulas. But many of these formulas struggle to capture the development of a market situation over a long period of time and it is not proven if they can be utilized for game economies. Therefore will this work not include in-depth coverage of economic math but rather refer to economic functions on special occasions to explain certain phenomena documented in some of the created prototypes. To build a more in-depth understanding of the mathematical structure of economic systems “Basic Economics – Economics for all” (Andrei, 2013), “Handbook of Monetary Economics” (Friedman & Woodford, 2011), and “The stability of models of money and growth with perfect foresight” (Sargent & Wallace, 1972) are recommended places to start.
