Principles of Economics
Carl Menger
Chapter 4. The Theory of Exchange
Menger opens by noting that Adam Smith never explained why people exchange goods (Wealth of Nations, Book 1, Chapter 2). Perhaps Menger is somewhat unfair, since Smith's remarks are more extensive than suggested here.
Menger first gives examples (not included here) of situations in which individuals would not exchange, to show that there is no benefit intrinsic to the act itself (people don't trade just because they enjoy it).
(4.i.1) 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.
(4.i.4) 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.
For Menger, economizing (rational maximizing) individuals exchange in order to increase satisfaction of their needs. The key element is that people value a unit of a commodity differently. One unit of grain is valued differently by Farmers A and B. Again, a subjectivist view of value.
(4.i.6) 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...is assumed to have had an excellent vintage in the same year. But his cellar is still filled from previous years, and...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...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.
(4.i.7) 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.
(4.i.8) As an example, let us suppose that...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...Thus, although to the grain farmer a certain portion of his grain...and to the wine grower a certain portion of his wine...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 [bushel] of grain...has a certain value to the first farmer by no means excludes the possibility that a [keg] of wine...may have a higher value to him...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.
Knowledge and power are once again the key ingredients (like Adam Smith's "reason and speech.").
(4.i.10) 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.
Following the central theme of Adam Smith, individuals act in their self-interest.
(4.i.11) 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.
A numerical example is provided to illustrate the incentive for exchange. The method is similar to the example on value provided in Chapter 3.
(4.ii.7) Suppose...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.
(4.ii.8) For greater clarity, let us cast the situation just described in numerical form. 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.
(4.ii.9) 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:
| A | B | ||
| Horses | Cows | Horses | Cows |
| 50 | 50 | 50 | 50 |
| 40 | 40 | ||
| 30 | 30 | ||
| 20 | 20 | ||
| 10 | 10 | ||
| 0 | 0 | ||
(4.ii.10) [I]t is easily seen that the basis for economic exchange operations is here present...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.
| A | B | ||
| Horses | Cows | Horses | Cows |
| 50 | 50 | 50 | 50 |
| 40 | 40 | 40 | 40 |
| 30 | 30 | ||
| 20 | 20 | ||
| 10 | 10 | ||
(4.ii.12) It is easily seen that each of the two traders obtained an economic gain from this first exchange...But it is just as certain that the basis for economic exchange operations has by no means been exhausted by this first exchange.
In a footnote, Menger criticizes the Germa economists who deny that there are economic benefits of trade. To Menger, it's not what goods you get (or an increase in the total number of goods as in James Mill' comparative advantage analysis), but the increase in the satisfaction of needs.
(4.ii.12.a) 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.
Menger continues with this analysis (with tables), taking it to the point of complete exchange to illustrate the limit of exchange, where total satisfaction is maximized.
(4.ii.24) 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.
(4.ii.25) 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.
One of the core foundation of Austrian economics. The world is constantly changing. The only equilibrium we reach is when exchange does not take place.
(4.ii.26) 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.
There are transactions costs in exchange, and these costs limit the extent of trade.
(4.ii.29) If men and their possessions...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...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 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 progress reduces transactions costs.
(4.ii.30) 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.
Since exchange contributes to increased satisfaction of needs, those involved in facilitating exchange are productive.
Welfare is not measured in goods, but in satisfaction of needs.
(4.ii.31) 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...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. Tradespeople 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.
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