Subjective Preferences, Transaction Costs And The Free Market Economy
If you want to understand the free market economy you need to be clear about what it is and how it works. Failing that, the tendency is to too easily lapse into well worn cliches and platitudes.
Elsewhere I defined the free market economy as based on the principles of voluntary exchange. To grasp what a free market economy is, though, it is essential to understand the functional effects of that principle. And the key effect is a general increase in social wealth.
On the matter of social wealth, though, let me explain. This term should not be misinterpreted as referring to some collective good. It is used here to refer to the aggregate wealth in a society, based upon the total wealth of the individuals who constitute the society. Voluntary exchange increases the wealth of the most people. It is only in this sense that I refer to social wealth.
So, we begin by asking how voluntary exchange achieves this increase of social wealth. It is often erroneously assumed that an exchange of goods cannot change the aggregate of social wealth. The items exchanged, to be exchanged, must be of equal value. Otherwise the market actors would not have made the trade. The only other option is presumed to be that one must have gotten the better of the other in the trade. In that case, though, the total social wealth would be unchanged.
This assumption is precisely mistaken. The analytical failure lies in confusion over a pair of essential economic facts: 1) transaction costs and 2) subjective preferences. Trades entail costs that are intrinsic to the transaction. Remember that in all trades both actors simultaneously buy and sell. Money, after all, is just another commodity being exchanged .
1) It's hard to see why a trader would bother making an exchange if he valued what he was buying equal to what he was selling. But even if he did do such a thing, for whatever whimsical reason, he would pay the price of a total loss in the process. This would be because, while the goods bought and sold were held as equally valuable, he would have to cover the transaction costs of the exchange.
Consider an example: imagine you're walking by the store front of your local grocer. If you valued the dollar in your pocket and the apple for sale in the store equally, you wouldn't care which you had. If you actually were so indifferent, would you detour from your journey to enter the store, find your way to the apple bin, peruse them in search of a ripe one, free of bruises, then walk over to the cashier and wait for the line to inch along until you reached the cashier and could pay?
All these expenditures of your time and energy are the transaction costs you incur when deciding to buy an apple. Why would you spend your time and energy in this way if you were truly indifferent to whether you had the dollar or the apple?
2) Here is the second point usually ignored in assuming exchanges of equal value: subjective preferences. If you're having difficulty getting your head around how two people exchange goods, with both being able to buy a good more valued that what they sold - that is, both can become more wealthy from the same exchange - it is this matter of subjective preference that you're missing. People have different values at any given moment in time.
Feeling hungry as you near the local grocery store could well have you value an apple more than a dollar in your pocket. Your greater valuation of the apple may be so much greater than the dollar that you'd happily incur the transaction costs (detour, perusal, waiting in line) to exchange dollar for apple.
That does not thereby make the apple objectively more valuable. This is just a manifestation of your current subjective valuing of the apple. Yesterday, while passing the grocer's, following a big lunch, not being at all hungry, subjective valuing of dollar and apple likely would have been quite different.
Likewise, the grocer's valuing of the goods is subjectively different from yours. He already has a bin full of apples, for which he has already paid. The funds he needs to run his store and support his family depends on actually selling the apples which he bought for just that purpose. The grocer values your dollar more than the apple and is as happy to make the exchange as is the hungry version of you. That's why the grocer is willing to incur the transaction costs of keeping the store clean, heated and well lit: it increases the likelihood you'll be willing to incur the transaction costs on your end.
Think about how often upon arriving at the cash, as you pay, both you and the grocer thank each other simultaneously. Is this some strange confusion or paradox? Of course not! You are both thankful, because you are both getting what you prefer: something you value more in exchange for something you value less. You are in fact both wealthier thanks to the exchange.
The result is that indeed total, aggregate social wealth has increased. Furthermore, this is not some anomaly but the guaranteed outcome of voluntary transactions. The secret of the free market economy is this win-win situation of voluntary exchange. And, the freer the market economy is, the greater the total social wealth that is generated.
Elsewhere I defined the free market economy as based on the principles of voluntary exchange. To grasp what a free market economy is, though, it is essential to understand the functional effects of that principle. And the key effect is a general increase in social wealth.
On the matter of social wealth, though, let me explain. This term should not be misinterpreted as referring to some collective good. It is used here to refer to the aggregate wealth in a society, based upon the total wealth of the individuals who constitute the society. Voluntary exchange increases the wealth of the most people. It is only in this sense that I refer to social wealth.
So, we begin by asking how voluntary exchange achieves this increase of social wealth. It is often erroneously assumed that an exchange of goods cannot change the aggregate of social wealth. The items exchanged, to be exchanged, must be of equal value. Otherwise the market actors would not have made the trade. The only other option is presumed to be that one must have gotten the better of the other in the trade. In that case, though, the total social wealth would be unchanged.
This assumption is precisely mistaken. The analytical failure lies in confusion over a pair of essential economic facts: 1) transaction costs and 2) subjective preferences. Trades entail costs that are intrinsic to the transaction. Remember that in all trades both actors simultaneously buy and sell. Money, after all, is just another commodity being exchanged .
1) It's hard to see why a trader would bother making an exchange if he valued what he was buying equal to what he was selling. But even if he did do such a thing, for whatever whimsical reason, he would pay the price of a total loss in the process. This would be because, while the goods bought and sold were held as equally valuable, he would have to cover the transaction costs of the exchange.
Consider an example: imagine you're walking by the store front of your local grocer. If you valued the dollar in your pocket and the apple for sale in the store equally, you wouldn't care which you had. If you actually were so indifferent, would you detour from your journey to enter the store, find your way to the apple bin, peruse them in search of a ripe one, free of bruises, then walk over to the cashier and wait for the line to inch along until you reached the cashier and could pay?
All these expenditures of your time and energy are the transaction costs you incur when deciding to buy an apple. Why would you spend your time and energy in this way if you were truly indifferent to whether you had the dollar or the apple?
2) Here is the second point usually ignored in assuming exchanges of equal value: subjective preferences. If you're having difficulty getting your head around how two people exchange goods, with both being able to buy a good more valued that what they sold - that is, both can become more wealthy from the same exchange - it is this matter of subjective preference that you're missing. People have different values at any given moment in time.
Feeling hungry as you near the local grocery store could well have you value an apple more than a dollar in your pocket. Your greater valuation of the apple may be so much greater than the dollar that you'd happily incur the transaction costs (detour, perusal, waiting in line) to exchange dollar for apple.
That does not thereby make the apple objectively more valuable. This is just a manifestation of your current subjective valuing of the apple. Yesterday, while passing the grocer's, following a big lunch, not being at all hungry, subjective valuing of dollar and apple likely would have been quite different.
Likewise, the grocer's valuing of the goods is subjectively different from yours. He already has a bin full of apples, for which he has already paid. The funds he needs to run his store and support his family depends on actually selling the apples which he bought for just that purpose. The grocer values your dollar more than the apple and is as happy to make the exchange as is the hungry version of you. That's why the grocer is willing to incur the transaction costs of keeping the store clean, heated and well lit: it increases the likelihood you'll be willing to incur the transaction costs on your end.
Think about how often upon arriving at the cash, as you pay, both you and the grocer thank each other simultaneously. Is this some strange confusion or paradox? Of course not! You are both thankful, because you are both getting what you prefer: something you value more in exchange for something you value less. You are in fact both wealthier thanks to the exchange.
The result is that indeed total, aggregate social wealth has increased. Furthermore, this is not some anomaly but the guaranteed outcome of voluntary transactions. The secret of the free market economy is this win-win situation of voluntary exchange. And, the freer the market economy is, the greater the total social wealth that is generated.
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posted by Vittoria @ April 17, 2014
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