in the army. He was captured and lived in prison camps for more than a year. Prisoners

at the camps received Red Cross packages that contained food, cigarettes, and a few necessities.

These were precious supplies in POW camps. At first, prisoners gave away the things they

didn’t like, but before long they started trading instead. Radford’s explanation of

this behavior may surprise you. Very soon after capture people realized that it was

both undesirable and unnecessary in view of the limited size and the equality of supplies

to give away or to accept gifts of cigarettes or food.

“Goodwill developed into trading as a more equitable means of maximizing individual satisfaction.”

More equitable? Really? Why would exchange be more equitable than gifts? Well, in a voluntary

exchange, both parties are better off, or they wouldn’t trade it all. Gifts are nice

but only the person receiving the gift is better off. Of course the giver might expect

a gift in return, but then, that’s exchange.

There are two reasons that this is important. Exchange corrects mistakes in allocation because

it moves stuff towards higher-valued uses. And exchange makes everyone who exchanges

a lot happier. There are two basic origins of exchange, and both are important.

First, same stuff different preferences. Let’s say we go on a field trip with boxed lunches

that each contain a sandwich, chips, pickle, and a cookie. I like chips and you like cookies.

I threw in my pickle to get you to agree, and we make the exchange. We’re both happier

with our lunches even though we’re still dealing with the same amount of food overall.

Second, there’s same preferences, different stuff. Suppose I have apples and you have

oranges, but we both prefer eating fruit salad with the two mixed together. If we exchange,

then we can both have fruit salad. We’re both happier with the same amount of fruit.

That’s remarkable.

In a world of scarce resources, each voluntary transaction means that people get happier

without any change to the total wealth that was available. That’s what makes trade so

powerful.

What if we have different stuff and different preferences? I do an exercise in class to

illustrate this. I give away T-shirts to my students, but I cheat. I make sure almost

every one of them ends up with the wrong size. So I ask, are you happy with your T-shirts?

Maybe 10 percent say that they are. Then I let them exchange shirts if they want to,

but only with their neighbors in the same row. Nonetheless, shirts move. You trade with

your neighbor, she trades with hers; the shirts travel around, improving the welfare of both

buyer and seller at every step. When it’s over, maybe 30 percent of the students are

happy with their shirt. It’s a big improvement but still not great.

Then I let people trade with anyone in the class. The class goes wild. Extra larges trade

for small, mediums for larges, and so on. It looks like chaos with people waving shirts,

calling out sizes. No plan, no direction, but at the end of trading, how many say they’re

happy? Ninety percent or more. The same number of shirts at the start, no one in charge,

and yet we went from 10 percent satisfied to 90 percent satisfied. Some of the shirts

changed hands many times. No one knew where the shirt was headed—it just went. And everyone

who exchanged was happier. It seems like magic, but it’s just markets.