Rothbard Chapter 2: Direct Exchange Part 2

Terms of Exchange

We have already learned that an exchange only happens if both traders have inverse rankings of the two goods and that each knows a trade is possible. Even in direct exchange, this trade leads to prices. However, these prices are not in dollars or euros, but simply a rate of exchange. If a cow trades for 5,000 berries, the prices of the cow was 5,000 berries. The price of 5,000 berries is 1 cow. But why 5,000 berries and not 4,000?

In chapter one, we learned that all action maximizes psychic revenue. The actor wants the highest possible ranking. Similarly, in any trade, the goal is the highest possible ranking, if it is above the psychic costs. This cost is what the actor gives up in the trade. It is his next best option.

It could be the cow he physically trades or something else he could get for a cow. Assume the actor has the following value scale of goods he can have-

  1. 5,000 berries from trader A
  2. 100 fish from trader B
  3. 4,000 berries from trader C
  4. 1 horse from trader D
  5. 1 cow from holding

Even though the person traded the cow for 5,000 berries, this is not the cost. The cost is 100 fish, his next best alternative. Also, clearly the actor prefers to deal with trader A than with trader C. The seller will always prefer the highest possible selling price and, conversely, the buyer will always buy at the lowest possible price. This give and take between buyer and seller determines the price of a good.

Determination of Price

In order for a trade to occur the highest buying price must be above the lowest selling price. If our above trader is selling a cow, the price in grapes must be above the 100 fish on his ordinal ranking. If we build a similar scale for the other trader, we will have the same conclusion. In an isolate exchange, this is all we can say about the price. It is not very satisfying.

However, trade is often not isolated, because there are multiple buyers and sellers on the market. Imagine that for the above ranking, 4,999 grapes, would be below 100 fish, so that 5,000 is the lowest acceptable price for the seller. Now, one more seller of cows for grapes enters the market. This person is willing to sell a cow for 4,900 grapes. Clearly, the buyer will no longer trade with the original seller, but switches to the new entrant.

How does this affect the price? Well now, the price is somewhere the lowest possible price from the lowest seller and the lowest price from the second lowest seller. Similarly, for buyers. the price is somewhere “at or below the maximum buying price of the most capable buyer and above the maximum buying price of the next most capable buyer” (pg 110).  As more buyers and sellers enter the market, this logic continues.

This has some standard economic results. If more and more buyers enter the market, the price must remain constant or rise, since these new entrants might raise the maximum of the most capable or second most capable if they are that person. The same for sellers. More sellers will lead to a lower price. More sellers and buyers will lead to an increase is quantity exchanged.

Supply and Demand

The graph from page 120 shows this. Notice the demand and supply curves are not continuous. Instead, at any price, a discrete number of new buyers and sellers might be willing to trade. This is standard supply and demand, derived from ordinal value scales, compared to maximizing a utility function, which is the standard method. From this framework, we can do all the comparative statics that are usually done with supply in demand.

Specialization and Production of Stock

Up to this point, the analysis has revolved around a given stock of goods. However, all goods must be produced. Even seemingly nature given goods requires effort to find and use.

As alluded to earlier, production requires a division of labor or specialization. Rothbard echos Adam Smith (Book I Part III- That the Division of Labour is Limited by the Extent of the Market) and David Ricardo (comparative advantage) when he states

"the further an exchange economy develops, the further advanced will be the specialization process. The basic of specialization has been shown to be the varying abilities of men and the varying" (pg 153-154)

These two attributes drive production, and therefore amount of goods (wealth) in an economy. Now the supply is from those who originally had the good and those who produced it, because it has exchange value.

Adding in production does not change the underlying supply and demand framework from above. Now, however, the goods have both use-value and exchange-value. If the ranking of the market price of a cow is above the ranking of the cost of raising a cow for certain individuals, they will enter the market and be a new seller. This will push the price down, again, standard supply and demand.

Conclusion

This chapter dealt with supply and demand in a unique way. Instead of assuming producers and consumers from the beginning, it starts from human action. Actors want to maximize their revenue and so trade. This develops into markets.

Notice that actors want to maximize psychic revenue and not psychic revenue minus psychic costs, i.e. psychic profit. In fact, the meaning of psychic profit is meaningless since we cannot subtract our fifth ranked cow from our first ranked 5,000 grapes for a profit of 4. It is wrong on two levels. First, adding and subtracting ordinal numbers is silly. Secondly, the fifth ranked cow is not the cost. The cost is the opportunity cost, which is the next best available alternative.

Without psychic profits, welfare economics cannot exist. I have written this before. This is a big problem for economists who view themselves as social planners who should make the world a better place by some measure of welfare or psychic profits. It also makes modeling collective action extremely difficult, even for economists from similar viewpoints.

Rothbard commits to ordinal rankings, opportunity costs, and subjectivism. Unless the reader pays attention to that, this whole process seems like a waste time. He spends almost 100 pages deriving supply and demand. For other textbooks, it takes a few questions. The other textbooks take shortcuts. Again, this has it benefits. Basic price theory is much easier to understand quickly, though supply and demand often lose their connection to action and exchange. Whether that trade-off has a higher ordinal ranking than Rothbard's method is why I am learning both.

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