Why Do We Exchange Things?

Michael Munger,

Release Date
April 12, 2013


Basic Economics

What can we learn about markets from a WWII POW camp? According to British economist R. A. Radford, POWs found that rather than give away unwanted rations to other POWs, “goodwill developed into trading as a more equitable means of maximizing individual satisfaction.” Professor Michael C. Munger explores what makes exchange more equitable than simply giving gifts. He finds that exchange is important for two reasons:
1.       It corrects mistakes in allocation by moving things toward higher-valued uses.
2.       It makes everyone involved in exchange happier.
Prof. Munger provides a few examples of how exchange can make people better off without changing the total amount of wealth available. In one case, two people each have the same items but different preferences. In this case, they will exchange so each one has more of his or her preference. In another case, two people each have a different item, but both prefer to have some of both items. They will exchange so each one ends up with some of each item and both are happier. Exchange can even make people better off when they have different items and different preferences. This is the power of markets.

The Economic Organization of a P.O.W. Camp[article]: Economist R.A. Radford recounts his tale of market development and exchange in the most unlikely of places – a Prisoner of War camp
Free Trade and Comparative Advantage

: How does trading make people better off? Economics professor Art Carden explains in this quick lesson on one of the most important concepts in economics: trade creates wealth
Desert Island Game (game, beginner): Can you learn something about trade and cooperation by being marooned on a desert island?
Trade Ruler (game, advanced): As the Supreme Ruler of an island, you want the country to prosper. By engaging in international trade, you can achieve this goal.
Trade and Specialization(video): A cadre of economic scholars explains the marvel of how specialization and trade saves us work and makes us better off
Gains from Trade(video): A short video explaining how specialization and exchange makes everyone better off
Treasure Island: The Power of Trade. Part II. How Trade Transforms Our Standard of Living[article]: Why did Bill Belichick become head coach of the New England Patriots instead of an economist? Trade, of course!
The Magic of Free Trade[article]: The benefit to society of free trade is so easy to see, even a fifth grader can understand!

Why Do We Exchange Things?

In 1944, at the height of World War II, a British economist named Radford was serving in the army. He was captured and lived in prison camps for more than a year. Prisoners at the camps received Red Cross packages that contained food, cigarettes, and a few necessities. These were precious supplies in POW camps. At first, prisoners gave away the things they didn’t like, but before long they started trading instead. Radford’s explanation of this behavior may surprise you. Very soon after capture people realized that it was both undesirable and unnecessary in view of the limited size and the equality of supplies to give away or to accept gifts of cigarettes or food.
“Goodwill developed into trading as a more equitable means of maximizing individual satisfaction.” More equitable? Really? Why would exchange be more equitable than gifts? Well, in a voluntary exchange, both parties are better off, or they wouldn’t trade it all. Gifts are nice but only the person receiving the gift is better off. Of course the giver might expect a gift in return, but then, that’s exchange.
There are two reasons that this is important. Exchange corrects mistakes in allocation because it moves stuff towards higher-valued uses. And exchange makes everyone who exchanges a lot happier. There are two basic origins of exchange, and both are important.
First, same stuff different preferences. Let’s say we go on a field trip with boxed lunches that each contain a sandwich, chips, pickle, and a cookie. I like chips and you like cookies. I threw in my pickle to get you to agree, and we make the exchange. We’re both happier with our lunches even though we’re still dealing with the same amount of food overall.
Second, there’s same preferences, different stuff. Suppose I have apples and you have oranges, but we both prefer eating fruit salad with the two mixed together. If we exchange, then we can both have fruit salad. We’re both happier with the same amount of fruit. That’s remarkable.
In a world of scarce resources, each voluntary transaction means that people get happier without any change to the total wealth that was available. That’s what makes trade so powerful.
What if we have different stuff and different preferences? I do an exercise in class to illustrate this. I give away T-shirts to my students, but I cheat. I make sure almost every one of them ends up with the wrong size. So I ask, are you happy with your T-shirts? Maybe 10 percent say that they are. Then I let them exchange shirts if they want to, but only with their neighbors in the same row. Nonetheless, shirts move. You trade with your neighbor, she trades with hers; the shirts travel around, improving the welfare of both buyer and seller at every step. When it’s over, maybe 30 percent of the students are happy with their shirt. It’s a big improvement but still not great.
Then I let people trade with anyone in the class. The class goes wild. Extra larges trade for small, mediums for larges, and so on. It looks like chaos with people waving shirts, calling out sizes. No plan, no direction, but at the end of trading, how many say they’re happy? Ninety percent or more. The same number of shirts at the start, no one in charge, and yet we went from 10 percent satisfied to 90 percent satisfied. Some of the shirts changed hands many times. No one knew where the shirt was headed—it just went. And everyone who exchanged was happier. It seems like magic, but it’s just markets.