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Saturday, July 08, 2006

The power of (free) trade

Plenty of folks disdain the market and the freedom for individuals to choose what they want to consume. These folks often consider the tastes and preferences of the masses as incompatible with "clean" or "good" living and figure that state allocation of goods and resources, typically according to their desires and not the desires of the masses, will yield a better outcome. Still others seem to have figured out that the government has taken it upon itself to choose winners and losers in many instances and have decided that it is fun if you can choose the winners (see ethanol, and other such policies).

Yet the power of free trade and individual decision making has never been greater. A great case in point is the kid who started with one red paper clip and attempted to trade his way to a new house. It took a year, but evidently he did it.

Start here:

End up here:

More here

How great is that? Granted there were a lot of transaction costs involved, and it isn't clear to me that each trade was strictly welfare enhancing for both parties involved (if you read the fine print you get the feeling that some people might have traded to "help" him along).

Some might be tempted to conclude that the experiment was a scam because it is obvious that a house is not worth a paper clip. However, such a conclusion would be incorrect. The trades that took place between the paper clip and the house suggest that within a neighborhood of value, individuals can trade for mutual gain. For example, the original trade was for a pen in the shape of a fish. In this trade, perhaps the person who originally had the pen needed a paper clip. On the margin, the paper clip was worth more than the pen and hence the trade.

Once having traded the pen for paper clip, our hero looks for someone else who is interested in a pen and, perhaps, has something that is of greater value than the original paper clip. It was, perhaps, easier for our hero to accomplish his goal because all he needed to find was someone who valued what he had enough to trade - he didn't have to exactly match up his preferences with someone else's.

It is unlikely that we could all go out with paper clips and in one year have a house. Not only are there too many transactions and increasing transaction costs involved, but, as described above, the barter system is a very inefficient way of organizing economic activity. This is where money comes into play. Not only is money a means of exchange but credit and savings allow us to consume today based on our future production or to consumer today using yesterday's production. Money helps reduce transaction costs which is why the One Red Paperclip is an interesting experiment but not a model for future economic transactions.

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