18 November 2009

A short lesson on the gains from trade

J. Shogren gave this example of "obviously. NOT!" at a conference

Consider four sellers who value their goods at $5, 4, 2 and 1.

Consider four buyers who would value these goods (should they possess them) at $10, 8, 3 and 2.

Now, how much can we increase surplus if we allow trading?

Calculate your answer in terms of the increase in surplus and then click "read more"
Now, a naive accounting would answer with an $11 increase in surplus ($10 buys from $5, $8 from 4, and so on...), but that accounting assumes that buyers can only buy from sellers, who must sell.

It we merely look at the "gains from trade," we will see that those who have the greatest values should end up with the goods. That means that new owners should be Mr10, Mr 8, Mr 5 and Mr 4 (total value 27). Judged against the starting value of 12, we can see that the gains from trade are really 15.

Bottom Line: Trade is about maximizing value, not buying and selling.

2 comments:

Anonymous said...

Why wouldn't Mr. 10 acquire all 4 units, for a surplus of 28?

David Zetland said...

Good question. There's an implicit assumption of "unit demand" -- one unit per person.