1. © Pilot Publishing Company Ltd. 2005 Chapter 7 Exchange

2. © Pilot Publishing Company Ltd. 2005 Contents: The Theorem of Exchange under Zero Transaction CostThe Theorem of Exchange under Zero Transaction Cost The Model of Exchange without Production under Zero Transaction CostThe Model of Exchange without Production under Zero Transaction Cost Benefits from Exchange Hindrance to Exchange – Transaction Costs

3. © Pilot Publishing Company Ltd. 2005 The Theorem of Exchange under Zero Transaction Cost

4. © Pilot Publishing Company Ltd. 2005 Assumptions: Private property rights are clearly defined. Transaction costs are negligible.

5. © Pilot Publishing Company Ltd. 2005 Reason for exchange: (necessary condition)  There exists a difference in marginal use values.

6. © Pilot Publishing Company Ltd. 2005 Process:  Low/High MUV individuals will sell the good to low/high MUV individuals. Low high Equilibrium:  Exchange will continue until MUVs / AUVs / TUVs of all individuals are equal. MUVs

7. © Pilot Publishing Company Ltd. 2005 Result:  Voluntary exchange is beneficial to all participants.

8. © Pilot Publishing Company Ltd. 2005 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.

9. © Pilot Publishing Company Ltd. 2005 The Model of Exchange without Production under Zero Transaction Cost

10. © Pilot Publishing Company Ltd. 2005 The model Initial situation: 2 individuals: A & B A owns X A0 & B owns X B0 Their MUVs are different. $ X 0A0A MUV A X A0 Individual A $ X 0B0B MUV B X B0 Individual B

11. © Pilot Publishing Company Ltd. 2005 Process of exchange: $ 0B0B MUV A $ 0A0A MUV B b X A0 X B0 X A1 X B1 Initial allocation of goods Final allocation of goods At H: MUV A * = MUV B * At b, MUV A > MUV B. Exchange is possible c Ms B (low MUV) will sell some of the good to Mr A (high MUV). Exchange will continue until point H is reached where MUV A * = MUV B *

12. © Pilot Publishing Company Ltd. 2005 Gains from exchange: $ 0B0B MUV A $ 0A0A MUV B bc X A1 X B1 P=MUV A *=MUV B * 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)

13. © Pilot Publishing Company Ltd. 2005 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)

14. © Pilot Publishing Company Ltd. 2005 An alternative illustration: X B1 Amount brought from B Amount sold to A X A1 MUV A 0 X X A0 $ P* X X B0 MUV B $ 0 A’s gain from exchange B’s gain from exchange P* $ X X= X A0 + X B0 0  MUV SS

15. © Pilot Publishing Company Ltd. 2005 Q7.3: If MUV curves of two individuals are identical, can mutually beneficial exchange occur between them? Explain.

16. © Pilot Publishing Company Ltd. 2005 Benefits from Exchange

17. © Pilot Publishing Company Ltd. 2005 Increase in total output through the reallocation of production  Through the reallocation of production, from low/high MC producers to low/high MC producers low high  more output is produced.

18. © Pilot Publishing Company Ltd. 2005  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

19. © Pilot Publishing Company Ltd. 2005 Hindrance to Exchange Transaction Costs

20. © Pilot Publishing Company Ltd. 2005 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

21. © Pilot Publishing Company Ltd. 2005 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

22. © Pilot Publishing Company Ltd. 2005 Gain of buyer Gain of seller Exchange with transaction costs: $ X0 P* X* SBSB DADA Total gain from trade If zero TC is involved in exchange Trade continues until MUVs are equal (where D meets S).

23. © Pilot Publishing Company Ltd. 2005 Buyer’s gain Seller’s gain If a positive per unit TC is involved in exchange (borne by the seller) X’ S B’ TC Ps’ Pb’ $ X0 X* SBSB DADA 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.

24. © Pilot Publishing Company Ltd. 2005 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?

25. © Pilot Publishing Company Ltd. 2005 Means to reduce transaction costs: Money  Hence transaction costs are greatly reduced and the 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

26. © Pilot Publishing Company Ltd. 2005 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.

27. © Pilot Publishing Company Ltd. 2005 Exchange with money and middlemen: S B’’ $ X0 SBSB DADA X’ S B’ Initial TC Ps’ Pb’ X’’ Reduction in transaction costs due to the presence of money and middlemen Pb’’ Ps’’ Volume of trade increases Additional gains from trade

28. © Pilot Publishing Company Ltd. 2005 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.

29. © Pilot Publishing Company Ltd. 2005 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.