- AMERICAN INSTITUTE FOR ECONOMIC RESEARCH - AUG 15, 2021 - Anthony Gill -
About a year ago, a former student of mine complained to me that they were being ripped off by a large Seattle-based coffee company (that shall go nameless to protect the innocent).
“What’s the problem?” I asked.
The student responded, “Every time I buy a 16 oz iced coffee, I only get about 8 ounces of coffee and the rest is ice. They should be charging me for the smaller size. It’s a rip off!”
“Every time?” I followed up.
“Yes. Every single time.”
This complaint may seem trivial, but underlying it is a much larger problem regarding why our younger generation is skeptical about the benefits of free markets and capitalism – they don’t understand the concept of “gains from trade” and how those gains are distributed. If people increasingly think that large corporations are out to soak them, they become more susceptible to calls for government intervention in the economy. Economic freedom wanes, and we all become worse off.
For this reason, it is important to set the record straight and help people understand the importance of the gains from trade. In doing so, I also will reveal, surprisingly, that sometimes consumers are the ones nefariously “ripping off” those corporate giants.
Understanding Gains from Trade
The concept of gains from trade is a basic building block of economic literacy, but one that is often forgotten, perhaps because it is so simple. Sophisticated college students and professors like complicated concepts, after all.
Gains from trade accrue when two individuals each have something that the other person values more and are able to complete an exchange of those things. When this happens, both individuals are better off (or at least one person is better off and no one is worse off).
Voluntary exchange (trade) produces wealth-enhancing gains for society. It is that simple.
Let’s illustrate this with an example from the world of retail coffee where my former student found himself “ripped off.” To protect his identity, I will use myself (Tony) as the hapless consumer squared off against the enormous market power of Barstucks, a fictional coffee company.
Assume I want a cup of coffee in the morning. Fortunately, a nearby Barstucks offers such a beverage. Since Barstucks has something that I want (coffee) and I have something they want (money), the potential for trade exists.
The next question, though, is on what terms will that exchange occur? More specifically, at what price will we trade?
To help us understand if trade is possible and how it produces economic gain, we must introduce the concept of reserve prices (a.k.a. reservation prices). A reserve price is the highest or lowest price an individual is willing to accept in a trade depending on if they are a buyer or seller. A reserve buy price is the highest amount the consumer would pay for an item. For the seller, a reserve sell price is the lowest amount they would accept in order to hand over an item voluntarily.
In Figure 1 below, I am willing to pay up to $5.00 for a cup of coffee. Barstucks has a reserve sell price of $2.00; below that price it will not provide coffee. The difference between my reserve buy price ($5.00) and Barstuck’s reserve sell price ($2.00) represents the total gains from trade, which is $3.00.
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