Monday, August 23, 2010

What the two-person economy tells us about the three-person economy

Suppose on a desert island there exist two people, Adam and Bob. Shipwrecked long ago, Adam and Bob have since developed for themselves a thriving two-person economy. Generally, each man tends to himself and his own activities, such as fishing and foraging for food, collecting rain water, and amusing himself using carved-out sticks of wood as musical instruments.

Occasionally, however, the two meet and voluntarily agree to make an exchange such that each believes he benefits from the exchange. For example, wood-carving-expert Adam may trade his newly created, wonderfully tuned, high-range recorder for some of fishing-expert Bob's delicious morning catch. It's not really up to us, as observers, to decide whether the exchange is a good one; if both Adam and Bob value themselves as benefiting from the exchange, then the exchange is, in their terms, a good exchange. Furthermore, if we assume that Adam and Bob are shrewd, rational persons who accurately perceive, according to their self-interest, proposed exchanges as being good or bad, then all exchanges are indeed good exchanges. Otherwise, a proposed exchange that is perceived as being a bad one by either Adam or Bob would result in the exchange being rejected.

Thus, it is claimed:

[A] A voluntary exchange benefits all participants in that exchange.

The rationale for A is like with our two-person economy of Adam and Bob. Because exchange participants do well with determining whether the exchange is good for them, a voluntary participant in an exchange must benefit from that exchange or else he would not have agreed to it.

Often, in economic philosophy centering around free-market principles, a second claim is made, based on A:

[B] Increasing the number of voluntary exchanges taking place in an economy increases the utility for all people in that economy.

The idea with B is that being how exchanges benefit all of their participants, exchanges are therefore wholly good things and should thus be maximized in order to maximize the benefit for all people. Claim B differs subtly from A: A makes a claim about what happens to the participants in an exchange; B makes a claim about what happens to both participants and non-participants alike.

People who make claim B often do so as though, given the validity of A, B must be true and needn't any further defense. Usually, their arguments go, we should strive for a free-market-based economy. QED.

However, it is not true that B necessarily follows from A. Imagine the following scenario.

Suppose on our desert island, instead of there being only Adam and Bob, there is also Casey and a thriving three-person economy. Adam and Bob decide to engage in an exchange with each other. Adam trades his high-range recorder not for seafood but for a special, wood-carved part that Bob has made that will allow Adam to complete construction of Adam's shrimp-cleaning machine. The machine will allow Adam to clean shrimp in less time than it takes for him to do so manually. Both Adam and Bob correctly perceive themselves as benefactors from the exchange.

However, Casey has a highly sensitive, fatal shellfish allergy, and Adam's shrimp-cleaning machine spews pieces of shrimp meat in all directions when in use. Casey now must avoid Adam's machine when in use, for if any piece of shrimp gets in the coconut pie that Casey is eating, then Casey will go into anaphylactic shock. Furthermore, Casey is a light sleeper and annoyed by recorder music, and Bob's habit of playing his high-range recorder all through the night decreases the quality of Casey's sleep.

In this example, though both participants of the exchange benefit, the non-participant of the exchange is harmed by the exchange. This example, though contrived, is not exceptional. It is easy to imagine real-world examples where a non-participant of an exchange is harmed. Perhaps you are nearby a cigarette smoker who traded money to the store for those cigarettes whose smoke is now blowing into your face. You are now being harmed by the smoker's exchange with the store.

This illustrates the problem with B: B assumes that people not participating in an exchange are unaffected by that exchange. This assumption is not always so, as shown by the example of Adam, Bob, and Casey and by the example of you, the cigarette smoker, and the store. Thus, we should reject B in that sometimes exchanges are not good for everyone and that increasing the number of exchanges in an economy does not necessarily lead to increasing the benefits for everyone in that economy.

What does this say about free markets? I think this says nothing about them. Perhaps free-market economies are best; perhaps they are not. Claim A does not lead to claim B, and by rejecting B and without further premises, we have no inclination either for or against free markets. In short, the two-person economy tells us nothing about how the three-person economy works. Exchange beneficence does not scale linearly.

An important take-away point here is that people who base their argument for a free-market economy solely on claim A are committing a fallacy. This does not necessarily mean that their conclusion is wrong, for fallacious arguments can still be correct, but it means that we will be prudent to be skeptical of their conclusion without further argumentation.

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