Transaction Costs and Intermediation

Release Date
June 29, 2017

Topic

Basic Economics Economics
Description

How transaction costs can block trade, and intermediation can keep it going — even in a POW camp. Watch more with Dan Russell.
Russell, Daniel. “Transaction Costs and Intermediation.” YouTube. Learn Liberty, 29 June 2017.

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Dan Russell: Transaction cost and intermediation. Imagine two prisoners in a POW camp. Call them Allen and Barry. Allen and Barry each receive exactly the same rations at exactly the same time. Let’s focus on just two of their rations, cigarettes and tins of beef. Allen and Barry both have cigarettes and beef, and they have them in the same quantities. What’s not the same is their preferences for cigarettes and beef. If Allen would rather have extra beef instead of cigarettes, then he might be willing to pay as many as six of his cigarettes for another tin of beef. If Barry would rather have extra cigarettes instead of beef, then he might let his tin of beef for as few as three cigarettes. It’s pretty clear that such a difference in preferences between Allen and Barry would create a trade opportunity. If they agreed on a price of four cigarettes for one tin of beef, then Allen would get a tin of beef for fewer cigarettes than it was worth to him, and Barry would get more cigarettes for his beef than it was worth to him.
Notice that even though there is only a fixed stock of goods between them, Allen and Barry could both be more satisfied with what they have, just by moving those goods around. We might say that prior to trading, the goods are misallocated because there’s another way of allocating them that would increase people’s satisfaction with those goods. Trading creates value simply by correcting that misallocation, but there’s a catch, because it costs something to correct that misallocation. In the POW camp, prisoners live in separate bungalows, and it isn’t always easy to move between the bungalows. Besides that, there may be language barriers and cultural barriers between different groups of prisoners. Suppose Allen sets out with his cigarettes, looking for someone who will trade a tin of beef. How long might that take? How many calories might that burn? Is there any guarantee he’ll even find the trade he’s looking for, and even if he finds someone willing to trade, how can he be sure he’s getting the best price he could? How can he be sure he can even trust the people that he’s trading with?
Transactions can create value, but transactions are costly to make, and that’s bad news because the greater the transaction costs are, the fewer opportunities there are for people to correct misallocations through trading with each other. However, this means that there is value to be created for other traders by specializing in reducing the costs of their transactions, and that is what arbitrageurs do. An arbitrageur is a kind of intermediary or middleman, who specializes in buying things where their price is lower and reselling them where their price is higher. For example, an arbitrageur might pay Barry four cigarettes for his tin of beef, and then sell it again to Allen for five cigarettes. The arbitrageur himself receives one cigarette out of the deal for his trouble, but Allen and Barry both still come out ahead on the deal as well, and that’s important to see. Even though the deal required paying one cigarette to the arbitrageur, the value of that one cigarette is still less than it would have cost to make that transaction without the arbitrageur.
The arbitrageur reduced the transaction cost by making it his specialty to know exactly where the best trade opportunities were. People can create value just by trading, and that is why trading arises spontaneously to correct misallocations, but trading involves transaction costs, and these can slow or even hinder the creation of value. It’s for that reason that specialist intermediaries also arrive spontaneously, reducing transaction costs, and thereby facilitating the creation of value.