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.