Chapter 7
Exchange
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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
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The Theorem of Exchange
under Zero Transaction Cost
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Assumptions:
• Private property rights are clearly defined.
• Transaction costs are negligible.
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Reason for exchange:
(necessary condition)
There exists a difference in marginal use values.
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Process:
Low MUV individuals will sell
 Low/High
the good to low/high
high MUV individuals.
Equilibrium:
Exchange will continue until
MUVs MUVs
/ AUVs / TUVs of all individuals are
equal.
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Result:
Voluntary exchange is
beneficial to all participants.
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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.
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The Model of Exchange
without Production
under Zero Transaction Cost
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The model
Initial situation:
2 individuals: A & B
A owns XA0 & B owns XB0
Their MUVs are different.
$
$
Individual A
Individual B
MUVA
0A
XA0
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X
MUVB
0B
XB0
X
Process of exchange:
At H: MUVA* = MUVB*
$
$
0A
0B
b
c
XA0
XA1
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XB0
XB1
At
Exchange
Msb,B (lowwill
MUV)
MUV
MUV
continue
will sell
until
some
point
of
A>
B. H
is Exchange
the
reached
goodwhere
toisMr A
possible
MUV
(highAMUV).
* = MUVB*
Initial allocation of goods
Final allocation of goods
Gains from exchange:
$
Gain of A
(Buyer’s surplus or
consumer’s surplus)
$
P=MUVA*=MUVB*
Gain of B
(Seller’s surplus or 0A
producer’s surplus)
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b
XA1
0B
c
XB1
Market transaction:
$
Supply
curve of B
portion of his MUV curve)
P*
0
Equilibrium price (P*)
and quantity transacted
(X*) are determined by
Mr A’s demand curve (a
and Ms B’s supply curve
X*
Demand
curve of A
X
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(her inverted MUV curve)
An alternative illustration:
$ A’s gain from
exchange
P*
$
$
B’s gain from
exchange
P*
0
P*
MUVA
X 0
MUV
MUVB
X
XA0 XA1
Amount brought
from B
S
XB1 XB0
Amount sold
to A
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0
X= XA0 + XB0X
Q7.3:
If MUV curves of two individuals are identical, can
mutually beneficial exchange occur between them?
Explain.
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Benefits from Exchange
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Increase in total output through
the reallocation of production
Through the reallocation of production,
from low/high
high MC producers
low MC producers to low/high
more output is produced.
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Increase in total use value through
the reallocation of consumption
Through the reallocation of consumption,
low MUV consumers to low/high
high MUV consumers
from low/high
 TUV of the goods produced increases
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Hindrance to Exchange
Transaction Costs
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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
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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
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Exchange with transaction costs:
If zero TC is involved in exchange
Trade continues until MUVs are equal (where D meets S).
$
SB
Gain of buyer
Total gain
from trade
P*
Gain of seller
0
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DA
X*
X
If a positive per unit TC is involved in exchange
(borne by the seller)
The per unit TC shifts the supply curve upwards.
Trade ceases where the difference in MUVs can just cover the TC.
SB’
$
Buyer’s gain
TC
Pb’
Ps’
Seller’s gain
0
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DA
X’ X*
SB
Qt drops and
both buyer’s gain
and seller’s gain
decrease.
X
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?
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Means to reduce transaction costs:
Money
In a monetary exchange
The act of sale & the act of purchase are separated
Double coincidence of wants is no longer required
Hence transaction costs are greatly reduced and
the volume of monetary exchange increases greatly.
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Means to reduce transaction costs:
Middlemen
- 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.
- Being middlemen, they greatly reduce the
number of transactions.
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Exchange with money and middlemen:
SB’
SB’’
$
Pb’
Additional Pb’’
gains from
trade
Ps’’
Ps’
0
Initial TC
SB
DA
X’ X’’
Reduction in
transaction costs
due to the
presence of
money and
middlemen
X
Volume of trade increases
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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.
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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.
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