A First Principles Framework to Economics and Finance

Photo by Sean Pollock on Unsplash

Preamble

It’s been a full year since I wrote my piece “What’s To Be Optimistic About 2021?” I wish I could write more. Still, I would like to share the following piece with you. While I initially thought about writing a piece similar to last year on looking ahead to 2022 (I am still very optimistic), I thought best to write the following piece — one that I have titled “A First Principles Framework to Economics and Finance.” This will be a seven part series covering a handful of topics starting from the very beginning. Hopefully this can be a great introductory piece for someone that’s new to the discipline to gain a more systemic view around these topics. Perhaps this can be an evergreen piece that can serve as a reference for years to come.

The essay will be released in seven-part series covering the following topics:

  1. Assets, Labor and Technology
  2. Division of Labor and Trade
  3. Money
  4. The Formation of Corporations
  5. Specialization and the Value Chain
  6. Key Components of Economic Activities and Their Numerical Representations — Financial Statements
  7. Financial Systems and Governments

Part 1. Assets, Labor, and Technology

Let’s start from the beginning. The foundation of human existence is quite simple. A person needs food and shelter to survive. Humans’ basic economic activities are aimed toward this purpose — to survive and continue to live. The beauty of this world is that we are endowed with this amazing planet — Earth. All economic activities start with this planet. In this essay, we will call all the things that Earth provides for human survival Assets (“A”). Trees, fertile land, fruits, animals, water are all forms of Assets. Another name for Assets used in Economics is Capital (“K”). For the purpose of this essay, we will use A and K interchangeably.

In an Economic Production Process, humans exert our energy in the form of Labor onto the Assets endowed by our planet, creating valuable Outputs. Labor (“L”) is simply the actions of people exerting effort and utilizing these Assets to produce Outputs/things that are needed to support and enhance human existence. Chopping down trees to build a shack, farming land to grow potatoes, using a spear to catch fish, are all forms of adding Labor to Assets to create Outputs/things of value to human existence. This is what I will call the Economic Production Process.

How well or how efficiently a person is able to create valuable Outputs using Labor and Assets is what we will broadly call Technology (“T”). Technology is what allows valuable economic activities to take place — where Outputs that are more valuable than its Inputs can be created from the Inputs of Labor and Assets. One can also think of Technology as the function that describes the relationship between Inputs and Outputs of Economic Production.

This is the foundation of economic activity — creating things that are useful/necessary for humans to live/survive. Together, we have now introduced the three foundational pieces of economic production — Assets, Labor and Technology. In Economics, this is called the Production Function. The Production Function describes the fundamentals of economic activity — one uses Technology to apply Labor to Assets to create useful Outputs. Said another way, the level of Outputs is a function of (i) the amount of Labor, (ii) the amount of Assets and (iii) the Technology. This is usually a positive relationship. Improving Technology, adding more Labor, or adding more Assets will generally lead to more Outputs.

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