© pilot publishing company ltd. 2005 chapter 7 exchange

© Pilot Publishing Company Ltd. 2005

Chapter 7 Exchange


Contents:

• The Theorem of Exchange under Zero Transaction Cost•The Model of Exchange without Production under Zero Transaction Cost• Benefits from Exchange• Hindrance to Exchange – Transaction Costs


The Theorem of Exchange under Zero Transaction Cost


Assumptions:

• Private property rights are clearly defined.

• Transaction costs are negligible.


Reason for exchange: (necessary condition)

There exists a difference in marginal use values.


Process: Low/High MUV individuals will sell the good to low/high MUV individuals.

Lowhigh

Equilibrium:Exchange will continue until MUVs / AUVs / TUVs of all individuals are equal.

MUVs


Result:

Voluntary exchange is beneficial to all participants.


Q7.1:Are theft and donation examples of exchange? Explain.

Q7.2:Take the exchange of sparkle cards or stamps as an example to illustrate the theorem of exchange.


The Model of Exchange without Production

under Zero Transaction Cost


The model

Initial situation: 2 individuals: A & B

A owns XA0 & B owns XB0

Their MUVs are different. $

X0A

MUVA

XA0

Individual A$

X0B

MUVB

XB0

Individual B


Process of exchange:

$

0B

MUVA

$

0A

MUV B

bXA0 XB0

XA1 XB1

Initial allocation of goods

Final allocation of goods

At H: MUVA* = MUVB*At H: MUVA* = MUVB*

At b, MUVA > MUVB. Exchange is possible

At b, MUVA > MUVB. Exchange is possible

c

Ms B (low MUV) will sell some of the good to Mr A (high

MUV).

Ms B (low MUV) will sell some of the good to Mr A (high

MUV).

Exchange will continue until point H is reached where MUVA* = MUVB*

Exchange will continue until point H is reached where MUVA* = MUVB*


Gains from exchange:

$

0B

MUVA

$

0A

MUV B

b cXA1 XB1

P=MUVA*=MUVB*

Gain of A (Buyer’s surplus or consumer’s surplus)

Gain of A (Buyer’s surplus or consumer’s surplus)

Gain of B (Seller’s surplus or producer’s surplus)

Gain of B (Seller’s surplus or producer’s surplus)


Market transaction:

$

X0

Supply curve of B

Demand curve of A

P*

X*

Equilibrium price (P*) and quantity transacted (X*) are determined by Mr A’s demand curve (a portion of his MUV curve) and Ms B’s supply curve (her inverted MUV curve)


An alternative illustration:

XB1

Amount brought from B

Amount sold to A

XA1

MUVA

0 XXA0

$

P* P*

XXB0

MUVB

$

0

A’s gain from exchange B’s gain from

exchange

P*

$

XX= XA0 + XB0

0MUV

S


Q7.3:If MUV curves of two individuals are identical, can mutually beneficial exchange occur between them? Explain.


Benefits from Exchange


Increase in total output through the reallocation of production

Through the reallocation of production, from low/high MC producers to low/high MC producerslow high

more output is produced.


Through the reallocation of consumption,from low/high MUV consumers to low/high MUV consumers

Increase in total use value through the reallocation of consumption

TUV of the goods produced increases

low high


Hindrance to Exchange Transaction Costs


Transaction costs (TC)

Transaction costs (交易費用 ) are all those costs that cannot be conceived to exist in a Robinson Crusoe economy. or a one-man


Examples of transaction costs:

Institutional costs

Cost of defining and enforcing property rights

Cost of acquiring information

Cost of determining price and forming other details of the contract

Cost of enforcing contract


Gain of buyer

Gain of seller

Exchange with transaction costs:

$

X0

P*

X*

SB

DA

Total gain from trade

If zero TC is involved in exchange Trade continues until MUVs are equal (where D meets S).


Buyer’s gain

Seller’s gain

If a positive per unit TC is involved in exchange (borne by the seller)

X’

SB’

TC

Ps’

Pb’

$

X0X*

SB

DA

Qt drops and both buyer’s gain and seller’s gain decrease.

Qt drops and both buyer’s gain and seller’s gain decrease.

Trade ceases where the difference in MUVs can just cover the TC. The per unit TC shifts the supply curve upwards.


Q7.4(a) If the per unit transaction cost is wholly borne by the buyer, will the prediction change?

(b) If the per unit transaction cost is shared equally between the buyer and the seller, will the prediction change?


Means to reduce transaction costs:

Money

Hence transaction costs are greatly reduced andthe volume of monetary exchange increases greatly.

Double coincidence of wants is no longer required

In a monetary exchange

The act of sale & the act of purchase are separated


Means to reduce transaction costs:

Middlemen

- Being middlemen, they greatly reduce the number of transactions.

- Being specialists or experts, middlemen have more information and are more skilful in bargaining, negotiating and enforcing contracts. Hence they can greatly reduce the costs involved in transactions.


Exchange with money and middlemen:

SB’’

$

X0

SB

DA

X’

SB’

Initial TC

Ps’

Pb’

X’’

Reduction in transaction costs due to the presence of money and middlemenPb’’

Ps’’

Volume of trade increases

Additional gains from trade


Correcting Misconceptions:

1. For an exchange between two individuals to take place, each individual must have a surplus in one good and a shortage in another good.

2. If the MUV curves of two individuals are identical, there cannot be mutually beneficial trade between them.


Correcting Misconceptions:

3. Exchange will occur if MUVs are not the same across individuals.

4. If the transaction cost of an exchange is borne wholly by one of the two trading parties, that party will gain less from exchange while the other party will gain more.

© pilot publishing company ltd. 2005 chapter 7 exchange

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