Value, Money, and Markets

Let me preface this all by saying that I have aboslutely no formal training in Economics. I have done some layman's study, but I am not an Economist.

I'll say that again, only this time in big bold letters.

I am NOT an Economist

OK... Now that this fact is understood, I can continue with what I want to say. Please accept (and correct) any flaws in my analysis, or errors in my understanding of economic principles with a grain of salt.

Although I am not an economist, I have developed quite a fascination with the economy of Second Life. Its quite interesting to see the reactions of SL residents (both vocal reactions, and behavioral reactions) to changes in this economy.

The SL Forums have had a lot of discussion that involves simply understanding what economic principles are at work. So I would like to take some time to discuss "value" and "money", since these two concepts are at the very core of much economic analysis. And then I would like to take these two concepts, and analyze how they apply to markets in Second Life.

VALUE

Let's first talk about "value". I'll relate this idea of "value" to all of the discussion that happened when land prices soared in SL over this past summer. Land prices were shooting through the roof, and you heard over and over again, "There's no way that land is worth this much". Yet, people kept buying at the high prices.

So how does an economist determine the value of something? This is a fundamental question, if one is going to evaluate trends and motives and needs and the like. Many people in SL over the summer were wrestling with the question of what is the true value of land.

This is the best answer I ever found about what economic value is: "something is worth whatever you think it is worth".

Now this would, at first glance, looks like the economist is side-stepping the question, but it is not. It is fundamental to the concept of "value", and is the point that must be understood if we are to understand value in an economic sense. Value is an entirely subjective metric.

If one person thinks that land is worth L$5/m2, and another thinks it is worth L$20/m2, they are both right.

What this means is that when one person was buying land at L$20/m2, and another was shaking their head in amazement at the foolheartiness of such an act, both were simply reflecting their own subjective notions of what the value of that land was. Neither was wrong.

The person who valued land at L$5/m2, and was unable to acquire that land because someone valued it more might get frustrated and angry. But it doesn't make the L$20/m2 person wrong.

The other thing that is important to understand about value is that its constantly in flux. Our wants and needs are constantly changing, and our perceived notions of the value of things change right along with it.

To give an extreme and somewhat humorous example of this let me relate an experience I had many years ago. I was living in Nova Scotia, and my father and his wife were visiting me and my wife at the time, and we decided to hike a 13km trail out to a lovely lookout on the Bay of Fundy called Cape Split. Let's just say that on the way back, I would have paid twenty bucks for a roll of toilet paper.

Value is affected by need, by desire, by location, and by a whole host of factors. It is constantly changing. If I already have 5 dozen eggs in my fridge, am wondering what I am going to have to cook to use all these eggs before they go bad, and an egg salesman comes to my door offering me eggs for a nickel a dozen, I'm probably going to tell him to thanks but no thanks. But the same guy coming some other time when I have no eggs in my fridge will probably get my business. My sense of the value of a dozen eggs is constantly in motion.

Value is completely subjective, and nobody's valuations are invalid. Each individual has a notion of value for each and every economic transaction they engage in, and these notions of value are constantly changing.

MONEY

With the concept of value defined, let's now talk about "money". In Second Life, the currency that is used is the Linden dollar (L$).

In economic terms, money is simply a mechanism to facilitate the exchange of goods and services. I'll use a simple SL example to illustrate this point. Let us consider the case where we have 3 different "sellers" of goods or services offering their wares in SL.

People sell because they want something in place of what they have. Take for example, someone who is selling t-shirts in SL who wants a scripter to write him a script, while we have someone else who has furniture and wants a t-shirt instead, and a scripter who wants some furniture.

If the first person who wants the script didn't have the convenience of money, he would have to wait until a scripter came along and saw the value of the t-shirts to be equal or exceed the value of his scripting skills. Similarly, the second person would not be able to get the t-shirt that he wants, because the first person doesn't place any value on the furniture that is being offered.

Without money, it would be very difficult for people to exchange goods and services. What money offers is something of "value" that is common to anyone who wishes to engage in commerce. Its simply something that facilitates the exchange of goods and services.

Money makes it possible for the furniture seller to exchange their furniture for L$, allowing him to exchange those L$ for the t-shirt that he wants, and which allows the t-shirt vendor to hire the scripter that he needs. Without money, the only way that this could happen would for the scripter, the t-shirt seller, and the furniture seller to get together and do a 3-way transaction. That's not very convenient, making it difficult for anyone to achieve their goal.

For money to work as a facilitator of commerce, its very existence must be limited and controlled. This limitation and control need not come from a government or some central authority, although that is how most of the world does it today. In ancient times gold was used as the vehicle of commerce, because nobody could just go out and create more money (well... except for gold miners, I suppose... but there is value in what they do, namely the value of the gold itself).

In Second Life, the Lindens have offered to be the controller of the currency, and we have accepted their offer. We have accepted them to do this as a matter of trust and convenience. In the USA, the citizenry has accepted the US Treasury and Federal Reserve Board to handle this responsibility.

We all know that the Linden dollars that exist are nothing more than bit patterns stored as the magnetic polarization of tiny particles on a platter of metal spinning around in some datacenter in California. Polarized particles on a metal disk typically don't have much value in and of themselves, but because we trust the Lindens to manage and control how those bit patterns are used and shared, they suddenly have value to everyone.

So walla... money has value. The value of money is derived from the trust and acceptance that we have placed in the Lindens to control and manage it. No trust, no money... Its as simple as that.

But this begs the question, "what is this money worth"? If we return to the definition of "value", then the answer is clear... "this money is worth whatever you think it is worth".

To illustrate this point, I'll consider two residents of Second Life. Since this isn't the Second Life forums, I can use real SL Avatar names without fear of retribution, and will use a couple of well-known SL residents.

Toy Lafollette is a friend of mine, and she has developed a well-deserved reputation as one with great talents and skills in creating "water". She teaches classes on how to use and animate water textures, how to mold prims into lovely looking shapes, and is personally responsible for a lot of the water you see in SL. She also has worked hard on building a lovely homestead in Jenner, and enjoys her life in SL very much (at least that is my perception... she may correct me).

I have heard Toy mention on several times that she doesn't do anything for the money. People will often pay her for her help in their builds, but to her its not that important. She derives great pleasure just in the act of building and creating. From Toy's point of view, the "value" of money is low to non-existent.

Anshe Chung is another well-known resident in Second Life. I don't know Anshe very well, and have only spoken with her on a few occassions. I must say that she has always been pleasant, and I have enjoyed our few chats.

Anshe has, much to the chagrin of many SL residents, embraced the free-spirited economic model of Second Life, and has created what I can only assume is a profitable business buying and re-selling land. Like any business, I'm sure that it has its ups and downs and risks and rewards. But whatever her level of success, this is how she has chosen to live her Second Life. I personally think the vicious attacks on her are unwarranted and mean-spirited, but that is neither here nor there, and not relevant to the point I am making. I only reference Anshe because she is well-known.

But I use Anshe as an example because for her, those bit patterns that represent L$ have a lot of value. They are central to her business, naturally making her perception of the value of money greater than Toy's.

Is Toy's perception of the value of money wrong, and Anshe's right? Or is it vice versa?

The answer is clear. If we go back to the definition of "value", then we see that the correct answer is that "they're both right".

Either Toy's or Anshe's perception of the value of money may be closer to someone else's sense of value, but that doesn't make either right or wrong. If I had to say where my sense of the value of money is, I'd say that it is closer to Anshe's than Toy's. But that certainly doesn't invalidate Toy's sense of value.

The point of this is that money has value because we have all agreed to let it have value. We have agreed to this because a) we have confidence in the Lindens to control and manage this money and b) it makes commerce much more convenient. Despite the fact that we have all agreed to this arrangement with the Lindens, it does not mean that we all value money the same. Everyone's sense of the value of money is their own subjective sense, and all are equally valid.

VALUE, MONEY, AND MARKETS

We now know what value is, and we know how and why money is valued. So let's take a look and see how these apply to what happens in our Second Life.

If you look around SL, you'll see thousands and thousands of goods and services being offered in exchange for L$. There exist entire sims dedicated to facilitating this by bringing together buyers and sellers. Judging by the economic statistics that are released by Philip Linden on a monthly basis, there is a whole lot of buying and selling going on.

People buy land, people buy clothes, people buy vehicles, people buy sex. In my case, I like it when they buy drums and joints. These transactions happen all the time, and are at the core of much that is Second Life.

So let's examine these transactions while considering our understanding of value and money that has already been discussed. I'll use the example of my t-shirt vender, and we can see what is happening. We'll give him a name, and call him "Joe Avatar".

Joe spent some time and effort bringing his t-shirt into SL by creating the image in Photoshop or Gimp, uploading the texture, adjusting the sliders, saving the clothing, stocking a "vendo" object, finding locations to place his vendos, etc. And at the end of his efforts, there is something of value there. This thing of value is one of Joe's t-shirts.

What is the value of this t-shirt? Remember... its whatever you think it is worth. Everyone who considers the purchase of one of Joe's shirts is going to make their own, subjective decision as to its value.

Joe, of course, has his own notion of what the value of his t-shirt is. He may think of all the effort it took, and how good he thinks his AV looks when wearing it, and will come to his own value judgement. But Joe is just another individual, drawing his own conclusions as to the value of the t-shirt.

Where commerce will occur is whenever a potential purchaser's perceived value of the shirt exceeds the price that Joe is asking. If Joe thinks his t-shirt is so fantastic that its worth L$500 and prices it accordingly, the only ones who might buy it are those that perceive its value to be L$500 or greater.

So buyers have their notions of value, and sellers have their notions of value, and wherever those notions overlap, a transaction can occur.

It gets a little trickier when you also consider that the buyers' and sellers' sense of the value of money may be different. A buyer who doesn't think much of the value of L$ might be willing to pay more for the shirt than someone else who values the shirt just as much, but has a much higher valuation of money.

So our sense of the value of goods and services, bundled with our sense of the value of money, all come together to determine if a transaction occurs. If the sum total is such that the buyer's sense of value exceeds the seller's sense of value, then the buyer gets his t-shirt, and Joe gets his L$.

Every time a transaction occurs, these valuations are occuring in each of us. When I decided to price my drum scripts at L$200 per drum, I considered, without even thinking about it, my sense of the value of the L$ along with my sense of the value of my scripts and set out a vendo that will give these scripts to anyone who is willing to pay me that L$200. And everytime that someone buys one, they perceive the value of those scripts to exceed what I am asking.

Does this mean that the person who doesn't have much interest in drums, and won't pay a single L$ for my scripts is wrong in his valuation? No! It just means that his evaluation and mine don't overlap, so there won't be a transaction. His perception is just as valid anyone who does buy the scripts.

And let's extend this back to the runup in the price of land that happened last summer, and that had everyone up in arms. At that time, there existed a pool of sellers and their perceived notions of the value of their land, and there existed a pool of buyers and their perceived notions. At that time, there was a lot of overlap at prices that would be unheard of today.

Were these valuations that occurred last summer wrong? Absolutely not. There was a seller and a buyer and their valuations overlapped and so a transaction occurred. And it happened quite a bit.

I don't want to get into competition analysis (what happens to the value of Joe's t-shirts when someone else makes a better t-shirt) or price elasticity (what price should Joe set for his t-shirt to maximize the money he gets), because, as I mentioned at the top, I am not an economist, and would probably butcher the analysis.

The point I am trying to make is that whenever a transaction occurs, it is valid, the price is correct, and everything is good, whether another agrees with the valuations or not.

But I do want to touch briefly on money and valuations and markets by referring to Gaming Open Market (GOM). Linden Labs has always encouraged the free exchange of the L$ currency to and from US$. This is to encourage people to create content by offering them a means to realize real-world money (which we ALL know has value) as a result of their efforts.

GOM is a place where buyers and sellers of the L$ currency can come to exchange between the US$ and the L$. Its a website that is modelled on the trading markets that exist in most of the world.

The benefit of an open, centralized marketplace such as GOM, where all the buyers and sellers can come together, is that every buyer and every seller can be assured that they are finding the best price for what they are offering. Bids and asks are placed, and those that want to buy or sell can see what is being offered at what price.

As this happens, each individual is making their own subjective judgements on both the value of the L$ and the value of the US$. Each publishes what their valuation is, and then others can look to see if there is a valuation overlap so that a transaction can occur. Furthermore, this sort of marketplace assures buyers and sellers that they are getting the best price.

This type of central marketplace is great for commodities, such as currency (a commodity is something that is the same, no matter what the source... a bushel of corn is a bushel of corn is a bushel of corn, just like a L$ is a L$ is a L$, no matter where it came from), and GOM has done a wonderful job creating an effective marketplace for these transactions to occur.

CONCLUSION

The point of this entire discussion is to put the commercial activity of Second Life through the economist's lens. After using this lens, we can see that by the very fact that commercial transactions are occuring in Second Life, there is something of value there. Everyday, people are making these value judgements, and doing (or not doing) business as a result.

We also can realize that everyone's notion of value can be (and almost always is) unique, and is constantly in a state of flux. Land prices go up, and land prices go down. The price in US$ of the L$ goes up on GOM, and it comes down. All this really means is that people's value perceptions are changing. But we knew that they constantly change anyway, right?

- Ace