What it means
The classic setting is coinage. If a silver dollar and a base metal dollar are both legal tender at $1, but the silver in one is worth far more than a dollar, shoppers hand over the base metal coin and keep the silver at home.
The key condition is a compulsory exchange rate. In a free market the better coin would simply trade at a premium and both would keep circulating, so it is the legal requirement to accept both at face value that pushes the good money out of circulation.
The idea generalises well beyond metal. Any market where buyers cannot tell quality apart, but sellers can, tends to see good products withdrawn and poor ones dominate, which is the same logic that underlies the economics of used cars and low quality lending.
There is a widely discussed mirror image sometimes called Thiers' Law: when confidence in the official currency collapses entirely, people stop accepting it at all and good money drives out bad. Hyperinflation episodes where a population switches to a foreign currency are the usual illustration.
Practitioners meet the principle in less dramatic forms. Fixed internal transfer prices, flat rate reimbursement schemes and one-size-fits-all pricing all create the same incentive to supply the cheapest acceptable version and hold back the good one.
In practice
Real-world examples.
Example
A national mint changes the composition of its highest value coin from 90% silver to a copper and nickel blend, keeping the same face value. Within three years the older coins have almost vanished from tills, collected by dealers who pay a premium well above face value.
Example
A retail chain sets one flat reimbursement rate for all supplier returns regardless of item condition. Suppliers quickly work out that only the most damaged stock is worth returning, and the quality of returned goods deteriorates sharply.
Example
A country pegs its currency to the dollar at an official rate that is far off the black market rate. Exporters keep their dollars offshore and settle local bills in the weak domestic currency, so hard currency largely disappears from the banking system.
Formula
Calculation
Melt value = metal content in troy ounces x metal price per troy ounce
Hoarding occurs when melt value is greater than face value
Suppose an older half dollar coin contains 0.36 troy ounces of silver and a newer half dollar of identical legal value contains no precious metal at all. With silver at $25.00 per troy ounce, the older coin has a melt value of 0.36 x $25.00 = $9.00 against a face value of $0.50, a ratio of 18 to 1.
A shopkeeper who sorts 2,000 old coins out of the till is holding metal worth 2,000 x $9.00 = $18,000, while the same coins would buy 2,000 x $0.50 = $1,000 of goods if spent. The gain from withdrawing them from circulation is $18,000 - $1,000 = $17,000, which is why within a few years virtually every coin still changing hands is the base metal version.Case study
Seen in the real world.
The following is an illustrative and fictional case. Bellweather Vending, an invented operator of coin machines, ran 900 machines across a city when the national mint replaced its silver quarter with a base metal version of identical size and face value. Both remained legal tender and both worked in the machines.
Over the next eighteen months the fictional company's coin counters noticed the mix shifting. Silver quarters had made up roughly a third of collections in the first month and were under 2% by month eighteen, as customers separated them out and sold them to metal dealers rather than feeding them into a machine.
The operations manager turned the observation into a modest side business, paying staff a small bonus to sort silver coins out of the daily count and selling them by weight. It was a neat illustration of Gresham's Law from the receiving end: the machines still took every coin at $0.25, so the public rationally kept the ones worth many times that and spent the rest.
Watch out
Common mistakes.
- Quoting the law as a general claim that low quality always wins, when it only applies where an official or contractual rate forces two different things to be treated as equal.
- Confusing the direction of the effect and saying good money drives out bad, which describes the opposite situation of a currency collapse rather than the ordinary case.
- Assuming the bad money disappears, when in fact it is the good money that leaves circulation while the inferior money keeps changing hands.
Questions
People also ask.
Does Gresham's Law apply to modern paper and digital money?
Only loosely, since notes have no metal value, though the principle still shows up wherever an official exchange rate is held away from the market rate.
Who was Gresham?
Sir Thomas Gresham was a sixteenth century English financier and royal agent, though the underlying observation had been described by others well before him.
Is there a business version of the law?
Yes, in any market where quality is hard for the buyer to verify and price is fixed, sellers have an incentive to supply the lowest acceptable quality.
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