Principle 4: Voluntary and informed exchange benefits the traders.
Objectives:
Define mutual coincidence of wants
Define and give examples of search costs, transaction costs, and opportunity cost
Explain how money facilitates exchange
Give examples of different ways to reduce transaction costs
Why do you want to learn this?
Some people place money on top of their list of priorities. The problem with that is that money is simply a tool that helps transfer resources owned by those people into the goods and services that they want. Acquiring resources (for most of us mainly human capital) to earn the money to achieve their monetary goals is the key. Human capital to money to stuff. Money makes that exchange much easier. You want to know this!
If you were asked to identify the greatest invention in the world, you could consider many candidates. Certainly the wheel would be one, it transformed the way that people transported goods and services. The internal combustion engine driven tractor could be another; it helped reduce the proportion of the labor force in the U.S. that produced food from 97% in 1800 to less than 3% today. Certainly, another candidate would be the microchip, which provides people with more computing power in their homes today than any of the manned space ships to the moon. But some economists would claim that something we don’t think about much as an “invention” may be the greatest of them all….money.
The concept of money is pretty overwhelming. Before money, barter was the major method of exchange. But barter can be very costly. In order to trade one good or service for another, the prospective traders have to use their human capital to find someone who has what they want, and is willing to trade it for what they have. Finding that person can take a great deal of human capital.
Let me introduce you to Fred. Fred was a caveman hut cleaner. He wanted to exchange his hut cleaning service for a club that could be used to defend himself against the bears in the neighborhood. He had to find someone who both had and was willing to exchange a club for having his or her hut cleaned. It was unlikely that Fred would find someone like that right away. Fred would have to travel the area to find such a person. In a barter economy, exchange can only occur if there is a mutual coincidence of wants, a situation where both parties want what the other party has. The mutual coincidence of wants means that Fred would have to use a bunch of his human capital travelling around trying to find this person. And while he was searching for the right person, he was giving up the opportunity to clean huts. People usually had to make many trades to get their own want satisfied. Searching is costly. Economists call this search cost. The more searching that Fred does, the fewer huts he can clean; barter exchange is inefficient.
Search costs can be dead weight losses. Often a cost to one person is a benefit to another. If you buy a bag of potato chips from a machine, that is a cost to you, but someone is going to get the money that you paid. Your loss is someone’s gain. A deadweight loss occurs when one party loses and no one gains. Search costs are dead weight losses to the extent that the searcher uses resources to find this mutual coincidence of wants. In this case they are a net loss to society...inefficient, a waste of resources.
Money minimizes search costs. With money, Fred only has to find someone who has a club for sale. He can clean the huts of people who want their huts cleaned, take the money and buy a club. The person he sells to and the person he buys from don’t have to be the same person because the seller knows that he can use the money to exchange for other things he wants. He cleans Bertha’s hut who wants her hut cleaned, and goes to Cassandra and buys the club. Cassandra doesn’t want her hut cleaned, but she is happy to accept the money from Fred and use it to buy things she does want. Everyone is happy and Fred didn’t have to use his human capital traveling the area looking for someone who had a club and was willing to trade it for a hut cleaning. Money serves as a medium of exchange, eliminating the need for a mutual coincidence of wants, making exchange less costly, i.e. more efficient.
Other transactions costs
When Fred was searching for someone with whom to trade, he was not using his human capital to do what he would have been doing. Search costs are a type of opportunity cost. A more general type of cost involved with exchange is “transaction cost.” Transaction costs are opportunity costs involved with facilitating an exchange. In layman’s terms, transaction costs are the hassles involved with exchanging goods and services.
One of the most obvious new transaction costs involved with travel is the nuisance that fliers are experiencing. To get on an airplane today, a flier must go to the ticket counter and show a government issued picture ID before obtaining a boarding pass. Then the flier must take her luggage to security, where the luggage that is being checked is inspected. Next, she must go through security, showing her ID and boarding pass, taking off belts and shoes, removing all metal items from her pockets, taking her computer out of the bag, and hoping that the screeners do not decide to open her carry-ons. Finally, she is subject to further inspection as she boards the airplane. While these security measures vary from airport to airport, the description above is fairly typical. What that means is that the flier must use a great deal of her human capital simply getting on the plane. The benefit of the security precautions may be worth the additional transaction costs; this is not an argument for or against these measures, it is simply a statement that the transaction costs of flying have increased dramatically in the last few years.
Another type of transaction cost is waiting in line for concert tickets, or paying for gasoline by taking your money into the store, going out and pumping the gas, then returning for change, or receiving a defective item in the mail and returning it. All of these are considered dead weight losses because the individual is incurring an opportunity cost and no one is receiving benefits. In the former Soviet Union, people would stand in line for hours and sometimes days to obtain items such as bread and toilet paper. Wealthier individuals would pay people to stand in line for them, increasing the cost to them of obtaining the products.
A hierarchy of costs
Opportunity cost is the best alternative foregone in choosing to use a resource one way rather than another. Transaction cost is a type of opportunity cost involved with making an exchange. Search cost is a type of transaction cost. The table below illustrates the relation between the three categories of costs.
Opportunity Cost | Transaction Cost | Search Cost | |
Eat a hamburger rather than a hot dog | Yes | No | No |
Study economics rather than chemistry | Yes | No | No |
Stand in line to return your books | Yes | Yes | No |
Pay for your gas, go back to get change | Yes | Yes | No |
Go to different jewelers to find a wedding ring | Yes | Yes | Yes |
Search the web for a textbook | Yes | Yes | Yes |
The more the costs of exchange can be reduced, the fewer the resources that are wasted in making the exchange, the more efficient the exchange. That is why money is such an amazing invention; it reduces the costs of exchange dramatically.
Other ways of reducing transactions costs
There are other methods of reducing transaction costs. Instead of paying cash at the gas station, some people use credit or debit cards, eliminating the necessity of going inside. People conduct transactions on the Internet, eliminating the trip to the record store or bookstore, or other store. Advertising can reduce search costs, as does the Internet. ATMs make money available to people 24 hours a day without requiring them to stand in lines waiting for a teller. Credit cards facilitate exchange on the phone, on the Internet and in the store. Having your wages and salaries deposited directly into your bank eliminates transaction costs. Posting menus outside of restaurants reduces search costs. All of these are methods of reducing the resources used in exchange, making exchange more efficient.
Bottom Line: Money is a medium of exchange which increases efficiency by reducing transactions costs. A search cost is a type of transaction cost; the cost of every choice is an opportunity cost.
1. Which of the following statements is true?
a. All opportunity costs are search costs.
b. All transaction costs are search costs.
c. All search costs are opportunity costs.
d. All opportunity costs are transaction costs.
2. Money makes exchange more efficient by:
a. Minimizing transaction costs
b. Eliminating the need for a mutual coincidence of wants
c. a but not b
d. both a and b
3. Which of the following is an opportunity cost
a. Using human capital to find the lowest priced gasoline
b. Using human capital to bargain with a car dealer
c. Using human capital to search the Internet for a pair of skis
d. All of the above are opportunity costs
4. Which of the following is a transaction cost?
a. Using human capital to find the lowest priced gasoline
b. Using human capital to bargain with a car dealer
c. Using human capital to search the Internet for a pair of skis
d. All of the above are transaction costs.
5. Which of the following is a search cost?
a. Using human capital to negotiate a loan from your local bank
b. Using human capital to find the best hamburger in town
c. Using human capital to wait in line for school books
d. All of the above are search costs.