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CHAPTER IV:  THE THEORY OF EXCHANGE

1. The Foundations of Economic Exchange

“WHETHER THE PROPENSITY OF men to truck, barter, and exchange one thing for another be one of the original principles in human nature, or whether it be the necessary consequence of the faculties of reason and speech,” or what other causes induce men to exchange goods, is a question Adam Smith left unanswered. The eminent thinker remarks only that it is certain that the propensity to barter and exchange is common to all men and is found in no other species of animals.[1]

     First, in order to clarify the problem, suppose that two neighboring farmers each have a great abundance of the same kind of barley after a good harvest, and that there are no barriers to an actual exchange of quantities of barley between them. In this case, the two farmers could give free rein to their propensity to trade, and could exchange 100 bushels or any other quantity of barley back and forth between themselves. Although there is no reason why they should desist from trading in this case if the exchange of goods, by itself, affords pleasure to the participants, I believe nothing is more certain than that these two individuals will forgo trade altogether. If they should nevertheless engage in this sort of exchange, they would be in danger, precisely because of their enjoyment of trade under such circumstances, of being regarded as insane by other economizing individuals.

     Suppose now that a hunter has a great abundance of furs, and hence of materials for clothing, but only a very small store of foodstuffs. His need for clothing is thus fully provided for but his need for food only inadequately. A nearby farmer is assumed to be in precisely the opposite position. Suppose too that there are no barriers to an exchange of the hunter’s foodstuffs for the farmer’s clothing materials. It is evident that an exchange of goods is still less likely in this case than in the first one. If the hunter should exchange a portion of his scanty store of food for a portion of the farmer’s equally scanty stock of furs, the hunter’s surplus clothing materials and the farmer’s surplus of foodstuffs would both become even greater than before the exchange. Since satisfaction of the hunter’s need for food and satisfaction of the farmer’s need for clothing were already insufficiently provided for, the economic position of the traders would be decidedly worsened. No one can maintain, therefore, that these two economizing individuals would experience pleasure from such an exchange. On the contrary, nothing is more certain than that the hunter and farmer will both most firmly resist offers to engage in a trade that would definitely reduce their well-being, or possibly even endanger their lives. If an exchange of this sort had nevertheless taken place, the two men would have nothing more urgent to do than to revoke it.

     The propensity of men to trade must accordingly have some other reason than enjoyment of trading as such. If trading were a pleasure in itself, hence an end in itself, and not frequently a laborious activity associated with danger and economic sacrifice, there would be no reason why men should not engage in trade in the cases just considered and in thousands of others. There would, in fact, be no reason why they should not trade back and forth an unlimited number of times. But everywhere in practical life, we can observe that economizing men carefully consider every exchange in advance, and that a limit is finally reached beyond which two individuals will not continue to trade at any given time.

     Since it has been established that exchange is not an end in itself, and still less itself a pleasure for men, the problem in what follows will be to explain its nature and origin.

     To begin with the simplest case, suppose that two farmers, A and B, have both previously been carrying on isolated household economies. But now, after an unusually good harvest, farmer A has so much grain that he is unable, however profusely he may provide for the satisfaction of his needs, to utilize a portion of it for himself and his household. Farmer B, on the other hand, a neighbor of farmer A, is assumed to have had an excellent vintage in the same year. But his cellar is still filled from previous years, and because he lacks additional containers he is considering pouring out a part of the older wine in storage which dates from an inferior vintage year. Each farmer has a surplus of one good and a serious deficiency of the other. The farmer with a surplus of grain must completely forgo consumption of wine since he has no vineyards at all, and the farmer with a surplus of wine is in want of foodstuffs. Farmer A can permit many bushels of grain to spoil on his fields when a keg of wine would afford him considerable pleasure. Farmer B is about to destroy not merely one but several kegs of wine when he could very well use a few bushels of grain in his household. The first farmer thirsts and the second starves when both could be relieved by the grain A is permitting to spoil on his fields and by the wine B has resolved to pour out. Farmer A could still satisfy his and his family’s need for food as completely as before and indulge besides in the enjoyment of drinking wine, and farmer B could continue to enjoy as much wine as he pleases but would not need to starve. It is therefore evident that we have encountered a case in which, if command of a certain amount of A’s goods were transferred to B and if command of a certain amount of B’s goods were transferred to A, the needs of both economizing individuals could be better satisfied than would be the case in the absence of this reciprocal transfer.

     The case just presented, in which the needs of two persons could be better satisfied than before by a mutual transfer of goods having no value to either of them prior to the exchange, and hence without economic sacrifice on either side, was especially suitable for impressing upon us in the most enlightening manner the nature of the economic relationship leading to trade. But we would construe this relationship too narrowly if we were to confine our attention to cases in which a person who has command of a quantity of one good larger than even his full requirements suffers a deficiency of a second good, while another person has a comparable surplus of this second good and a deficiency of the first. For the relationship in question can also be observed in less obvious cases in which one person possesses goods of which certain quantities have less value to him than quantities of another good owned by a second person who is in the reverse situation.

     As an example, let us suppose that the first of the two isolated farmers has not harvested so much grain that he can allow part of it to spoil on the field without injury to the satisfaction of his needs, and that the second does not have so much wine that he can pour any of it away without similar injury. Instead, each of the two farmers can employ the whole quantity of the good at his command in some fashion useful to himself and his household. The first farmer can employ his whole stock of grain usefully by devoting the quantity remaining after complete provision for the satisfaction of his more important needs to the fattening of his cattle. The second farmer does not have so much wine that he must pour some of it away, but just enough to permit him to distribute a portion to his slaves as a reward for greater effort. Thus, although to the grain farmer a certain portion of his grain (a bushel, for instance) and to the wine grower a certain portion of his wine (a keg, for instance) has only a small value, it nevertheless has some value, since directly or indirectly the satisfaction of certain of his needs depends on that portion. But the fact that a given quantity of grain, a bushel for instance, has a certain value to the first farmer by no means excludes the possibility that a certain quantity of wine, a keg for instance, may have a higher value to him, as would be the case if the enjoyment afforded by a keg of wine has a higher importance to him than the more or less thorough fattening of his cattle. Similarly with the second farmer, the fact that a keg of wine has a certain value to him by no means excludes the possibility that a bushel of wheat may have a higher value to him, as would be the case if it would ensure a more adequate diet for himself and his family, and perhaps even avoidance of the pains of hunger.

     The most general form of the relationship responsible for human trade is therefore as follows: an economizing individual, A, has a certain quantity of a good at his disposal which has a smaller value to him than a given quantity of another good in the possession of another economizing individual, B, who estimates the values of the same quantities of goods in reverse fashion, the given quantity of the second good having a smaller value to him than the given quantity of the first good which is at the disposal of A.[2] Let the quantity of the first good in A’s possession be 10a, and let the quantity of the second good in B’s possession be 10b. Assume the value of the quantity 1a to A to be W, the value of 1b to A if he should obtain command of it to be W + x, the value of 1b to B to be w, and the value of 1a to B if he should obtain command of it to be w + y. It is evident that A would gain a value of x and that B would gain a value of y from a transfer of 1a from A’s possession to B’s and 1b from B’s possession to A’s. In other words, after an exchange, A would find himself in the same position as if a good with a value to him of x had been added to his wealth, and B would find himself in the same position as if a good with a value of y to him had been added to his wealth.

     If, in addition, the two economizing individuals (a) recognize the situation, and (b) have the power actually to perform the transfer of the goods, a relationship exists that makes it possible for them, by a mere agreement, to provide better, or more completely, for the satisfaction of their needs than would be the case if the relationship were not exploited.

     The same principle that guides men in their economic activity in general, that leads them to investigate the useful things surrounding them in nature and to subject them to their command, and that causes them to be concerned about the betterment of their economic positions, the effort to satisfy their needs as completely as possible, leads them also to search most diligently for this relationship wherever they can find it, and to exploit it for the sake of better satisfying their needs. In the situation just described, therefore, the two economizing individuals will make certain that the transfer of goods actually takes place. The effort to satisfy their needs as completely as possible is therefore the cause of all the phenomena of economic life which we designate with the word “exchange.” It should be observed that this term is used in our science in a special sense with a much wider application than in popular or especially than in legal language. For in the economic sense it also includes purchase and sale, and all partial transfers of economic goods (tenancy, rental, lending, etc.) for compensation.

     If we summarize what has just been said we obtain the following propositions as the result of our investigation thus far: The principle that leads men to exchange is the same principle that guides them in their economic activity as a whole; it is the endeavor to ensure the fullest possible satisfaction of their needs. The enjoyment men derive from an economic exchange of goods is the general feeling of pleasure they experience when some event permits them to make a better provision for the satisfaction of their needs than would otherwise have been possible. But the benefits of a mutual transfer of goods depend, as we have seen, on three conditions: (a) one economizing individual must have command of quantities of goods which have a smaller value to him than other quantities of goods at the disposal of another economizing individual who evaluates the goods in reverse fashion, (b) the two economizing individuals must have recognized this relationship, and (c) they must have the power actually to perform the exchange of goods. The absence of but one of these conditions means that an essential prerequisite for an economic exchange is missing, and that an exchange of goods between two economizing individuals is economically impossible.

2. The Limits of Economic Exchange

     If each economizing individual had but a single good of each kind at his disposal, and if each of these goods were indivisible with respect to its goods-character, there would be no difficulty in investigating the limits to which exchange operations would proceed in each given case to result in the greatest economic gain for each participant. Suppose that A has a glass goblet and B a piece of jewelry made of the same material, and that neither of the two individuals has command of more than the one unit of each article. According to what was said in the preceding section, only two situations are conceivable: either the basis for an economic exchange between the two individuals exists with respect to the two goods, or it does not. If it does not, the question of an exchange cannot arise at all from an economic standpoint. And if it does exist, there can be no doubt that an actual exchange of the two goods will naturally preclude any further exchange of goods of exactly the same kinds between A and B.

     But whenever quantities of goods are at the command of different persons which can be subdivided into portions of any desired size, or which are composed of several discrete pieces, each of which is indivisible by nature or use, the situation is different.

     Suppose that A, an American frontiersman, owns several horses but no cow, while B, his neighbor, has a number of cows but no horses. Provided that A has requirements for milk and milk products and B for draft animals, it is easy to see that a basis for exchange operations is present. But no one will maintain that the exchange of one of A’s horses, for example, for one of B’s cows would necessarily exhaust the existing basis for economic exchange operations between A and B with respect to these goods. It is equally certain, however, that a basis need not necessarily exist for exchange of the total quantities they possess. A who owns (for example) six horses may be able to satisfy his needs better if he exchanges one, or two, or perhaps even three, of his horses for B’s cows. But from this it does not necessarily follow that he would derive an economic gain from the exchange transaction if he were to barter all his horses for all of B’s cows. Although the initial economic situation pro. vides a basis for economic exchange operations between A and B, the consequence of carrying the exchange too far might be that the needs of the two contracting parties would be less well provided for than before the exchange.

     The relationship we are now considering, in which not merely single goods but quantities of goods are at the disposal of men, can be regularly observed in human economy. An endless number of cases can be observed in which two economizing individuals have command of quantities of different goods, and in which the foundations for economic exchange operations are present, but where the gains to be derived from trade would be exploited only incompletely if the two economizing individuals were to exchange too little, and would be again diminished, reduced to nothing, or even converted to losses, if they should drive their exchange operations too far and exchange too much.

     But if we can observe cases where “too little” of an exchange does not yield the full gains to be derived from the exploitation of an existing relationship and where “too much” leads to the same result, indeed often even to a deterioration in the economic positions of the two traders, there must be a limit at which the full economic gains to be obtained from the exploitation of the given relationship are reached, and beyond which any exchange of further portions begins to become uneconomic. The determination of this limit is the object of the subsequent investigation.

     I shall present a simple case for this purpose in which we can most carefully observe the relationship we wish to consider, undisturbed by secondary influences.

     Suppose that in a virgin forest, far away from other economizing individuals, there live two frontiersmen who maintain friendly intercourse with each other. It is assumed that the compass and intensity of their needs are exactly the same. Each of them requires several horses to work his land. One horse is absolutely necessary if he is to be able to produce the food required for the maintenance of his and his family’s lives. A second horse is required to produce the somewhat greater amount of food needed for an adequate diet for himself and his family. Each of the farmers could use a third horse to transport the timber and firewood he finds necessary from the forest to his log cabin, to draw loads of sand, stones, etc., and to work a field on which he will raise some luxury foods for his and his family’s enjoyment. A fourth would be used solely for pleasure, and a fifth horse would have only the importance resulting from its availability as a substitute in case one of the other horses should become incapacitated. But neither of the frontiersmen could use a sixth horse. It is assumed also that each of them would need five cows to meet his full requirements for milk and milk products, that there is the same gradation in the importance of their needs for these products, and that a sixth cow could not be used by either of them.

     For greater clarity, let us cast the situation just described in numerical form (pp. 125ff.). We can represent the graduated importance of the satisfactions that are provided for by the possessions of the two frontiersmen with a set of numbers that decrease in arithmetic series, with the series 50, 40, 30, 20, 10, 0, for example.[3]

     Assuming that A, the first frontiersman, has 6 horses and only one cow, while B, the other frontiersman, has one horse and 6 cows, the successive degrees of importance of the satisfactions provided for by the possessions of the two persons can be represented in the following table:

     From what was said in the first section of this chapter, it is easily seen that the basis for economic exchange operations is here present. The importance a horse has to A is equal to o, and the importance a second cow would have to him is equal to 40. On the other hand, a cow has a value of o to B, while a second horse would have a value of 40 (p. 131). Thus A and B could both provide considerably better for the satisfaction of their needs if A were to give B a horse and if B were to give A a cow in exchange. There is no doubt that they would actually undertake this exchange if they are economizing individuals.

     The importance of the satisfactions that are provided for by the possessions of the two persons after this first exchange will be as follows:

It is easily seen that each of the two traders obtained an economic gain from this first exchange equivalent to the gain that would accrue to him if his wealth had been increased by a good whose value to him is equal to 40.[4] But it is just as certain that the basis for economic exchange operations has by no means been exhausted by this first exchange. For a horse still has much less value to A than an additional cow would have (10 as compared with 30), whereas a cow has a value of only 10 to B while an additional horse would have a value of 30 (three times the value of a cow). It is therefore in the economic interest of both economizing individuals to undertake a second exchange operation.

     The situation after the second exchange can be represented as follows:

It can be seen that each of the two persons derived an economic gain that is no less than if their wealth had been increased by a good valued at 20.

     Let us see whether there is a basis for further economic exchange operations even in this situation. A horse has an importance of 20 to A; an additional cow would also have an im­portance of 20 to him; and B is in a similar position. From what has been said, it is evident that an exchange of one of A’s horses for one of B’s cows under such conditions would not be worth while since there would be no economic gain at all.

     But suppose that A and B should nevertheless enter into a third exchange. If performance of the exchange did not require any appreciable economic sacrifices (costs of transport, loss of time, etc.) it is evident that the economic positions of the two men would be neither injured nor improved.[5] After this third exchange their positions would be as follows:

     Let us now ask what would be the economic result of still further exchanges of one of A’s horses for one of B’s cows. The situation after a fourth exchange would be:

     As can be seen, the economic positions of A and B are both less favorable after the fourth exchange than they were before. By acquiring a fifth cow, A has indeed assured the satisfaction of a need that has an importance of 10 to him. But to obtain it he has given up a horse that had the importance to him of satisfactions that were assumed equal to 30. His economic position after this exchange is exactly the same as it would be if his wealth had been reduced without compensation by a good with a value equal to 20. The same result can be observed with B. The economic disadvantage of the fourth exchange operation is mutual. Instead of gaining from it, A and B would both suffer an economic loss.

     If the two persons, A and B, should continue to exchange horses for cows, the situation after the fifth exchange would appear as follows:

     And after the sixth exchange it would be:

It is easily seen that after the fifth exchange of one of A’s horses for one of B’s cows the two traders would have returned to the same situation, with respect to completeness of provision for the satisfaction of their needs, that they were in at the outset of exchange operations. After the sixth exchange they would have worsened their economic positions considerably more. They could do nothing better than to revoke these uneconomic exchanges.

     What has been shown here in a single instance can be observed wherever quantities of different goods are in the possession of different persons and a basis for economic exchange operations is present. If we were to select other examples, we would find differences in secondary circumstances but not in the nature of the relationship explained.

     Above all we would find, in each instance and at any given point in time, a limit up to which two persons can exchange their goods to their mutual economic advantage. But we would find that they cannot overstep this limit without placing themselves in a less favorable economic position. In short, we would everywhere observe a limit at which the total- economic gains to be derived from an exchange relationship are exhausted, and beyond which these gains would be diminished by further exchange operations, making the exchange of any further portions uneconomic. This limit is reached when one of the two bargainers has no further quantity of goods which is of less value to him than a quantity of another good at the disposal of the second bargainer who, at the same time, evaluates the two quantities of goods inversely.

     Thus we see that in the reality of practical life men do not trade indefinitely and without limit. We see instead that particular persons, at any given time, with respect to any given kinds of goods, and in any given economic situation, reach a certain limit at which they cease to make further exchanges.[6]

     A social economy is made up of individual economies, and what has been said above is therefore just as valid for the trade of entire peoples as it is for single economizing individuals. Two nations, one chiefly engaged in agriculture and the other primarily in industry, will be in a position to satisfy their needs much more completely if each exchanges a portion of its produce for the produce of the other (the first nation a portion of its agricultural produce and the second a portion of its manufactures). But they will not undertake the exchange indefinitely and without limit. At any given point in time they will reach a limit beyond which any further exchange of agricultural produce for manufactures will be uneconomic for both nations.

     It is, of course, true that in the trade of individuals, and still more in the commerce between whole peoples, the values goods actually have for men can generally be observed to be subject to constant fluctuations. These fluctuations occur principally because new quantities of goods are continually coming into the hands of the various economizing individuals through the production process. As a result, the foundations for economic exchanges are constantly changing, and we therefore observe the phenomenon of a perpetual succession of exchange transactions. But even in this chain of transactions we can, by observing closely, find points of rest at particular times, for particular persons, and with particular kinds of goods. At these points of rest, no exchange of goods takes place because an economic limit to exchange has already been reached.

     Another observation made earlier concerned the gradually diminishing economic gains obtained by given economizing individuals from the exploitation of a given opportunity for trade. The first trading contacts of economizing individuals are usually the most advantageous economically. It is usually only later that opportunities for trade that promise smaller economic gains are also exploited. This is true not only of trade between individuals but also of the commerce between whole nations. If two peoples whose ports or boundaries were always or for some time previous closed to mutual intercourse open them suddenly to trade, or even if only some previous impediments to trade are removed, a very lively trade in goods develops immediately. For the number of trading opportunities to be exploited and the economic gains to be made are at first very great. Later, trade moves in the channel of normally profitable business. But if the full gains from the new trade are sometimes not immediately forthcoming, the reason is that the other two prerequisites of economic exchange, knowledge of the trading opportunities and power to carry through exchange operations recognized to be economic, are ordinarily acquired by the participants only after a certain period of time. Some of the most strenuous efforts of trading nations are directed toward removing impediments to trade in both these categories (by careful study of the commercial situation, by the construction of good roads and other means of transport and communication, etc.).

     Before I close this discussion of the foundations and limits of economic exchange, I wish to direct attention to an important factor that must be taken into consideration if the principles expounded in this chapter are to be correctly interpreted. I refer to the economic sacrifices that exchange operations demand.

     If men and their possessions (the economies of individuals[7]) were not separated in space, and if the mutual transfer of command of goods between one economizing individual and another did not therefore generally require the shipping of goods and many other economic sacrifices, the full economic gains resulting from an exchange transaction would accrue to the two participants. But such cases are very rare. Cases are indeed conceivable in which the economic sacrifices of an exchange operation fall to a minimum neglected in practical life. But it is not easy to find an actual case in which an exchange operation can be performed without any economic sacrifices at all, even if they are confined only to the loss of time. Freight costs, loading charges, tolls, excise taxes, premiums for marine and other insurance, costs of correspondence, commissions and other sales costs, brokerage charges, weighages, packaging costs, storage charges, the entire cost of the commercial banking system, even the expenses of traders[8] and all their employees, etc., are nothing but the various economic sacrifices which are required for the conduct of exchange operations and which absorb a portion of the economic gains resulting from the exploitation of existing exchange opportunities. Indeed, these economic sacrifices often render exchange impossible when it would be possible if only these “expenses,” in the general economic sense of the term, did not exist.

     Economic development tends to reduce these economic sacrifices, with the result that even between the most distant lands more and more economic exchanges become possible which previously could not have taken place.

     Implicit in what has been said is an explanation of the source from which all the thousands of persons who are intermediaries in trade derive their incomes. Because they do not contribute directly to the physical augmentation of goods, their activity has often been considered unproductive. But an economic exchange contributes, as we have seen, to the better satisfaction of human needs and to the increase of the wealth of the participants just as effectively as a physical increase of economic goods. All persons who mediate exchange are therefore—provided always that the exchange operations are economic—just as productive as the farmer or manufacturer. For the end of economy is not the physical augmentation of goods but always the fullest possible satisfaction of human needs. Trades people contribute no less to the attainment of this end than persons who were, for a long time, and from a very one-sided point of view, exclusively called productive.

[1]Adam Smith, op. cit., p. 13.

[2]The remainder of this paragraph appears here as a footnote in the original.—TR.

[3] I need hardly point out that the figures in the text are not intended to express numerically the absolute but merely the relative magnitudes of importance of the satisfactions in question. Thus when I designate the importance of two satisfactions with 40 and 20 for example, I am merely saying that the first of the two satisfactions has twice the im­portance of the second to the economizing individual concerned.

[4]These considerations completely disprove the contention of a number of economic writers (Lotz and Rau, for example, among the more recent German writers) who have denied the productivity of trade. The effect of an economic exchange of goods upon the economic position of each of the two traders is always the same as if a new object of wealth had entered his possession. Trade is therefore no less productive than industrial or agricultural activity.

[5]I classify indifferent exchanges such as this as definitely non-economic since in them the provident activity of men is set in motion aimlessly quite apart from all the economic sacrifices they may entail.

[6]The next paragraph appears here as a footnote in the original.—TR.

[7]“die menschlichen Wirthschaften”—TR.

[8]Carey’s portrayal of merchants as economic parasites because they claim a portion of the gain arising from the exploitation of the available opportunities for economic exchange transactions (op. cit., III, 23–25) is based on his erroneous ideas about the productivity of trade.

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