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Writer's pictureJim Charkins

6a: Two Principles of Exchange

Updated: Jun 13



Principle #4: Voluntary and informed exchange benefits the traders.


Objectives:


Give examples of two principles of exchange


Why do you want to learn this?

You know that people can’t have everything they want. You also know that benefit/cost analysis is an important tool in using resources as efficiently as possible to achieve your goals. But this lesson holds a real surprise — how to get something from nothing. That’s a pretty good trick and the beauty of it is that we all can do it and we all already do it. The something from nothing trick comes from one simple activity — exchange. Through the simple act of exchange (trade), society can increase happiness. The Principles of Exchange will help you realize when you pay more for something that your choice is voluntary.


Exchange Principle #1

If two people have two different things and each one values the thing that the other person has more than he values what he has, there is an opportunity to create wealth by the simple act of exchange. Assume that Pete has a baseball bat that he has outgrown. He swings a much heavier bat now. Sam has a pair of shoes that he has never worn. They were a gift; but they are the wrong size, and he can’t ask his aunt where she bought them because she doesn’t take kindly to people returning her gifts. The bat would be just right for Sam and the shoes would fit Pete perfectly, and he likes them. Pete values the shoes more than Sam does, and Sam values the bat more than Pete does. If they exchange these goods, both Sam and Pete are better off and their happiness has increased. This is the wonder of exchange….satisfaction is created without any additional resources. Society is better off because two people who valued two goods differently exchanged. The reason that it worked is because they both valued the products differently. In this case, “one person’s trash was another man’s treasure.”


From this comes Exchange principle #1: people will exchange if they expect to gain more than they give. This is really a summary statement of the benefit/cost analysis that was explored in the last two units. Armed with this encapsulation of benefit/cost analysis, students can explain many of the choices that people make. The principle will be used in later units to investigate markets, pollution, endangered species, the role of government, and much, much more.


Exchange causes satisfaction to increase for two reasons:

  1. People’s evaluations of things are subjective.

  2. People’s subjective evaluations of things are different.


Exchange Principle #2: Voluntary and informed exchange is a win-win situation; it is NOT a zero sum game.


When people exchange, they do so because they expect to gain something of greater value to them than what they are giving up. As a result, each exchange adds a small amount to the happiness of society, not because there are more things available, but because the existing things are in the hands of people who value them more highly. Voluntary and informed exchange is a win-win situation and increases society’s well-being. Some people think that exchange between two people in different countries is a zero sum game (one person wins, the other loses.) However, the beauty of the principle of exchange is that it knows no borders. Whether exchange is between people in the same nation or different nations, voluntary and informed exchange benefits both parties, it is a win-win situation.


Example – one person’s trash is another person’s treasure


A family drives to the mountains to play in the snow. They would like to take a bunch of snow home with them in the back of their pickup. A homeowner in the mountains would like her driveway cleared of snow. The family shovels the driveway and puts all of the snow in the back of their pickup. The homeowner is happy because her driveway is clear; the family is happy because they can go home and make snowmen and have snowball fights and impress the neighbors. Voluntary exchange has created greater satisfaction for both parties. The family gained the snow and gave up their human capital (shoveling); the mountain resident gained the snow shoveling service which she values highly, and gave up the snow which she doesn’t value at all. Both parties were better off.


Example: The price is high but I will gain more than I give


You go to the store to buy peaches. It is the beginning of the season and prices are very high. You think about it and think about it. The price is really high. In a few weeks, the price will be much lower. But the peaches are beautiful. The grocer cuts into one and lets you try it. It is delicious. You buy the peaches. The price is really high. Were you ripped off? This was voluntary exchange and you gained. You take those peaches home and you and your family have a wonderful time eating them. Wow, are they good! Others will look at the price you paid and say, “No way. That price is ridiculous. The value of those peaches isn’t as high as whatever else I would buy with the money. I’ll buy some apples at a lower price.” In both cases, the consumer makes the choice to buy the peaches or not, comparing the value of what she expects to gain against the value of what she expects to give up.


Voluntary purchases are examples of voluntary exchange, as exemplified by the peaches. People are often dissatisfied with what they consider “high” prices of some products. They buy the item, paying the “high” price, and then complain that they have been “ripped-off.” The principle of exchange suggests otherwise. People will not willingly exchange unless they expect to gain more than they give. So, unless someone was holding a gun to the buyer’s head, he must have gained more than he gave up, even though he gave up more than he wanted to. If a person buys gasoline and pays what she considers a high price, was she ripped-off by the “international oil conspiracy?” She claims that she had to buy the gas because she had to get to work. But, in fact, she compared the value of getting to work to the value of what she gave up to buy the gas. If the value of her getting to work is greater than the amount that she gave up to get the gas, then she gained from the exchange. She undoubtedly gave up more than she wanted to, but any price above zero is more than she would have liked to give up. In this case, the gas-station owner gains from the exchange or he won’t be in business for long, and the gas buyer gained from the exchange. This is not a statement about the price itself, whether the price is fair or unfair, it simply says that, by buying the gas, the customer demonstrated that the price is low enough for the buyer to buy the gas and gain more than he gave.


A glitch – imperfect information


Exchanges do not always turn out the way that one or both parties had expected. People often buy clothing that does not hold up to its original appearance after washing. As a result, they may not wear it as long as they had expected. Moviegoers sometimes discover that the trailers were the only interesting parts of the movie. Fruit is sometimes less inviting than it looks because it is either overripe or under ripe. College students sometimes take a course because the course description sounds interesting, only to discover that the teacher has no interest in teaching and is a serious bore. The problem is that people involved in exchange operate with incomplete information. In addition, one party in the exchange sometimes has more information than another. This is the case with many products that we consume such as medical care, highly technological products and financial exchanges. When one party lacks the same information as the other party, the actual increase in wealth may be lower than the anticipated increase. The more information that both parties have prior to the exchange, and the more equal that information, the more Bothlikely it is that both parties will realize their anticipated increase in wealth.


Another glitch –more than two parties and regulated exchange

Involving more than two people muddies the water a bit. If Joan trades with Jane, but used to trade with Joe, both parties in the exchange benefit but the third party is harmed. If governments put regulations on the exchange such as a tax on Jane’s product this changes things; trading with Joe is again a better deal than trading with Jane. Once again, two parties are harmed. Joan has to pay more and Joe loses his business. The tax changed the benefits for all three traders.

Applying the Principles of Exchange must be done with caution when some of the parties involved will be harmed.


Bottom Line:


People will exchange if they expect to gain more than they give.

In a voluntary exchange between two traders with equal information, both traders benefit. Voluntary and informed exchange is a win-win situation; it is not a zero-sum game. 

In exchanges with more than two parties or with government intervention, some parties are likely to be harmed.


1. In which of the following exchanges do both parties gain?

a. Charlene pays more than she wants to for a book at the bookstore.

b. David trades with Juan Carlos – an apple for an orange.

c. Sarah’s mother buys a Toyota from a dealer.

d. all of the above. 


2. Ruth has decided she wants a laptop to keep in touch with her grandchildren. She is a technology novice. The salesperson tells her that she has to have the highest graphics and sound capabilities as well as the fastest speed. The good news is that the best computer for her is on sale today for 205 off although the price is far above most of the others. Ruth walks out. What might lead you to believe that Ruth made a good decision? 

a. The exchange would not have been voluntary. 

b. Ruth and the sales clerk did not have the same knowledge. 

c. Both a and b. 

d. Neither a nor b.


3. Assuming that the exchange is voluntary and both parties have equal knowledge, which of the following would benefit both traders?  

a. An American buys an American product

b. An American buys a Chinese product

c. A German buys a Russian product

d. All of the above


4. In which of the following exchanges are there likely to be disadvantages to one party?

a. More than two parties are affected by the exchange.

b. Governments impose barriers to the exchange.

c. both a and b

d. Neither a nor b



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