Tuesday, June 14, 2005

The Economics of Alchemy

Reading Neal Stephenson's Quicksilver got me pondering the economics of alchemy. Specifically, what would have happened if alchemists had found a way to convert lead into gold? The most naïve answer is...

That society would have gotten rich, since gold was the leading medium of exchange and store of value (i.e., money) at the time. This answer is clearly wrong, because if gold had suddenly become a lot more common, its value would have fallen – a classic inflation story. There would have been more gold coins, but each gold coin would have purchased less than before. Also, “society” is too vague a word to describe the people affected by a change in the money supply, because gains and losses are not distributed uniformly. Some people benefit more from an increasing money supply than others – those who are the first recipients of an influx of new money. And this leads to the second hypothesis…

That the person or persons who invented alchemy would have gotten rich. This hypothesis is more plausible, but it depends crucially on the assumption that the conversion technique would have remained a trade secret. If the secret had ever gotten out, as seems likely, then the price of gold would eventually have fallen (close) to the marginal cost of producing it, including the price of lead and other raw materials, wages, etc. (Of course, the usual methods for producing – that is, finding and extracting – gold would have remained available, so the alchemical producers would have had to compete with traditional producers as well. But all the marginal mines – those with marginal extraction cost above the new lower price of gold – would have shut down.) Free entry into the alchemy business would have driven economic profits down to (near) zero. Although it’s plausible that some monarchs would have restricted entry to protect favored interests, it’s difficult for a monarch to restrict production in other nations. So does anyone benefit?

That the producers of lead would have gotten rich. The success of alchemy would have driven up the demand for lead, leading to higher prices. The owners of lead mines would have reaped higher profits, so long as their own production costs remained unchanged. This effect would have been limited by the opening of new lead mines in the marginal locations where mining would not have been economically feasible at lower lead prices. Still, the inframarginal mines (those that were profitable even at low lead prices) would have experienced a jump in value. This strikes me as the most plausible hypothesis, but it’s consistent with one other…

That society would have gotten slightly richer. Huh? Wasn’t that the first one? Well, yes, but the word “slightly” is key. Society would not have become richer simply from an expansion of the medium of exchange. But gold is valuable intrinsically; it can be used for certain production technologies as well as for jewelry (and money). By driving down the price of gold – reflecting a decrease in the opportunity cost of using it – alchemy would have raised the real incomes of all consumers of gold or goods produced using gold. In this sense, the success of alchemy would have been much like any other improvement in production technology.


Brandon Berg said...

I'm not sure I buy number 4. It seems like that the economic chaos caused by hyperinflation would undo the benefits of an increased supply of gold.

Anonymous said...

The inventor(s) of the lead-to-gold process would have a first-mover advantage, wouldn't they? After all, it'd take time for the supply increase to get filtered through the price signal mechanism, and for the knowledge of the conversion process to spread. During that time the inventors might be able to rake in a considerable profit.

--Nick Weininger

Alita said...

It occurs to me that the invention of manufactured diamonds and their impact on the diamond market can give us insight into to what the probable effects would be if someone introduced manufactured gold into the marketplace.

While it constituted a challenge to the diamond industry, the introduction of cubic zirconium jewelry has had minimal impact ultimately on the value of "real" diamonds. They might look like diamonds in many ways, but they have different physical, optical and chemical properties, making easily detectable as distinct from diamonds. On the other hand, in the last couple of years, the technology to manufacture diamonds has significantly advanced. There are now companies that are manufacturing and selling "diamonds" that do have the same physical, optical and chemical properties as those that are mined. They use machines to crystallize pure carbon by applying tremendous heat and pressure (think Superman crushing a lump of coal into a diamond with his bare hand.) There are still ways to detect the man-made from the natural, but the fact remains that these "cultured" diamonds are "real" in the sense that they are comprised of the same properties as mined diamonds...and that makes the introduction of these much more analogous to the case of manufactured gold.

Diamonds, like gold, have an intrinsic value. Diamonds can, as Glen says of gold, "...be used for certain production technologies as well as for jewelry..." Society will undoubtedly benefit from the ability to create an unlimited number of large optical grade diamonds, as it will enable technological advances ranging from lasers to semiconductors that might otherwise be limited either by cost or availability.

Of course, the industrial market for diamonds is different than that of the retail jewelry market, as different factors drive the value of jewelry than those that drive the value of machine components. As long as there are ways to identify the manufactured diamonds from the mined diamonds, albeit on a microscopic level, there will be more perceived value in jewelry made from the ones that are a limited resource.

For more information about these new diamonds, how they are made and their affect on the diamond market, I've included a few interesting links:

Articles about the new diamonds and their affect on the marketplace:
WiReD Article
60 Minutes II Report
Diamond Industry Article

About the technology and making them:
Carnegie/DOE Alliance Center
PNAS Online
Article About the CVD Diamond
Diamond Industry Article

Two main companies making them:

PS: The affect of cultured pearls on the value of natural pearls is actually quite different, but also interesting. Pearls are so rare in nature that we really wouldn't have a pearl market if it weren't for cultured pearls. If you're interested in their history, follow these links:
Background & History
Industry Guide

Unserious Talker said...

My guess is that some other "precious metal" would have replaced gold. Just a hunch though.

Bob Hawkins said...

What was the effect of Spain stealing all that gold from the Incas? Not as much as they expected, It seems.

(BTW, know where that gold is now? Moscow. During the Spanish Civil War, Moscow offered to keep the gold safe from Franco, and then made sure the Spanish government lost the war. Among other things, the Spanish Civil War was the biggest bank job in history.)

Anonymous said...

> What was the effect of >Spain stealing all
> that gold from the Incas? >Not as much as they >expected, It seems.

On the contrary, a huge European-wide inflation
took place in the century after 1550.

The gold did not stay in Spain, but went elsewhere.

Anonymous said...

I may have missed some missing assumptions. There was a story in some moderately reliable source such as Scientific American perhaps 30-40 years ago about a couple of students who bombarded lead with something in their neuclear lab an got some gold. Someone calculated it would cost several billion dollars per ounce. So if the alchemist had found something the entire economy may have been dumped into their futile effort.

Glen Whitman said...

Brandon -- yes, possibly, though it wouldn't be an out-of-control hyperinflation like that which results from an irresponsible monetary authority. I agree with KG that if gold became common enough, it would probably be displaced as the medium of exchange.

Anon of June 15 -- true, the inventors would have a first-mover advantage. My point was that they couldn't sustain profits in the long run.

Alita -- good point. I was implicitly assuming that manufactured gold and natural gold would be perfect substitutes.

Anon of June 16 -- if the cost of transforming lead into gold were too expensive, then the method wouldn't be used, of course. I was assuming the process was sufficiently inexpensive to be worthwhile. In any case, the "entire economy" would not be dumped into a futile project -- unless, of course, the decision was made by politicians instead of private citizens constrained by their own bottom lines.

tommi said...

I vote for the number four. Gold is very malleable and resistant to corrosion. If it costed about the same as, say, copper or iron, there might have been a lot of practical uses. Even in the medieval society.

Brett said...

Clearly 2: The alchemists would have gotten wealthy. While the process would eventually have leaked out, and reduced the price of gold to something similar to that of lead, until this happened the achemists would have been accumulating wealth. And knowing that gold was essentially worthless in the long run, they'd have accumulated it in some other form. They'd still have it when the price of gold crashed.

exFinancier said...

i usually buy a gold in this jewelry directory, good resource

Anonymous said...

Well it is true that lead extractors would have been rich and also the alchemists. But lets say only a very skilled alchemist can do this transmutation then only a couple of alchemists would have been rich and there are references for rich alchemists.

One morden example of transmutation is the artificial diamond. Here a natural carbon is transmutated in to a diamond in a lab. If a diamond can be made in a lab why not gold?

gold blogger said...

Have you ever heard that Russian alchemists have found a way to manufacture gold from lead at a cost of 400-600$ an ounce? They have never done it before because the manufacturing cost was too high. However, at today’s gold prices they are making a killing! What do you think?

jr said...

"If a diamond can be made in a lab why not gold?"

Gold is an separate element, diamond is just another form of carbon.