The Riddle is Transaction Costs: That's What the Money is For!
Jun 04, 2024Season 2Episode 1
Michael Munger
Can a single $100 bill solve an entire town's debt crisis? This riddle is a window into transaction costs. I rely on Jeffrey Rogers Hummel's insights, adding a few thoughts of my own.
And a cool letter: Ever wondered why you haggle for a car but not for your morning Starbucks's coffee?
Plus, a book recommendation: Nobel Prize-winning economist Edmund Phelps' "My Journeys in Economic Theory," a compelling read that blends economic insights with political theory.
Can a single $100 bill solve an entire town's debt crisis? This riddle is a window into transaction costs. I rely on Jeffrey Rogers Hummel's insights, adding a few thoughts of my own.
And a cool letter: Ever wondered why you haggle for a car but not for your morning Starbucks's coffee?
Plus, a book recommendation: Nobel Prize-winning economist Edmund Phelps' "My Journeys in Economic Theory," a compelling read that blends economic insights with political theory.
If you have questions or comments, or want to suggest a future topic, email the show at taitc.email@gmail.com !
You can follow Mike Munger on Twitter at @mungowitz
Speaker 1:
This is Mike Munger of Duke University, the knower of important things. This is the first episode of Season 2. A riddle about debt. Unsurprisingly, the answer is transaction cost. A new twedge plus this week's letter and more Straight out of Creedmoor. This is Tidy C. I thought they'd talk about a system where there were no transaction costs, but it's an imaginary system. There always are transaction costs. When it is costly to transact, institutions matter and it is costly to transact. Well, the riddle is from a blog post on EconLive by David Henderson in 2012. I've changed it a little. There are actually at least four main versions of this riddle that I found online, sometimes in different countries and different circumstances, but the main story is the same. Here's my version.
Speaker 1:
It's a slow day in some little town. The sun is hot, the streets are deserted. It's a slow day in some little town the sun is hot, the streets are deserted, times are tough, everybody's in debt and everyone lives on credit. On this day, a rich tourist from back west is driving through town. He stops at the motel, puts a $100 bill on the desk saying he wants to inspect the room upstairs at the hotel in order to pick one to spend the night. As soon as the man walks upstairs, the owner grabs the bill and runs next door to pay his debt to the butcher. The butcher takes the $100 bill and runs down the street to retire his debt to the pig farmer. The pig farmer takes the $100 bill and heads off to pay his bill at the feed store. Now the guy at the farmer's co-op takes the $100 bill and runs to pay his debt to the local prostitute, who has also been facing hard times and she's had to offer her services on credit. She, in a flash, rushes to the motel and pays off her room bill with the motel owner. The motel proprietor now places the $100 bill back on the counter just a few minutes before the rich traveler comes back out. Well, the rich fellow comes back down the stairs, he haughtily picks up the $100 bill, loudly complains that none of the rooms is satisfactory, pockets the money and climbs back into his Jaguar, disappearing in a cloud of dust to leave the little town once again in silence.
Speaker 1:
Now no one produced anything, no one earned anything, but the whole town is now out of debt and looking to the future with a lot more optimism. This shows how dangerous and, in fact, evil debt and capitalism are. All of the worries of the townspeople before were based on no real lack of resources. Everyone's debt problem was solved by having just a little more money for a few minutes, which, after all, money's not real value in the first place. Well, end of riddle. Now how should we think about this? Is it really true that nothing of value happened and yet the welfare of the town was increased? Well, david Henderson quotes from Jeffrey Rogers Hummel, the monetary economist at San Jose State. Here's what Jeffrey Hummel had to say, and I'm not quoting, I'm paraphrasing, but this is basically Hummel's answer.
Speaker 1:
There are several ways to think about this example. It is provocative. All the examples should recognize that the transactions made no change in any of the party's net wealth. So at the beginning, each resident does have a hundred dollar liability, that is, they have debt. And the example each resident does have $100 liability. That is, they have debt. And the example the riddle emphasizes that they have debt. But wait, they also had an offsetting financial asset. Someone owned them $100. So it balanced. Everyone in the example had both $100 debt and $100 asset in the sense, like an informal bond. Somebody owed them $100. $100 asset in the sense, like an informal bond. Somebody owed them $100. What happened was that each person used the $100 to pay off the debt, which meant that each person lost their asset of having someone owe them $100, but they gained the benefit of not having the liability of owing someone else $100. So there's no net change in their wealth. All that happened was that they used the $100 that they were owed to pay off the $100 that they were in debt. So the $100 bill acts as a clearing mechanism. Really, what that means is the answer is transaction cost. Now, that's me saying that, not not dr hummel, but he doesn't disagree.
Speaker 1:
Back to professor hummel. If you want to think about the town as a distinct economy, then the rich tourist has temporarily increased the town's money stock by a hundred dollars. In effect, he made a very short term loan of a new hundred dollar bill, increasing liquidity. The 100 provides the residents with a medium of exchange that allows them to clear their offsetting debts. Or, if you broaden the economy to include the rich tourist, his short-term loan is provided liquidity through increasing the transaction's velocity of money. If the rich tourist hadn't provided the loan, any of the residents could have accomplished the same result just by briefly borrowing $100 cash from someone else. Yes, no new final goods and services were produced because they'd all been produced already. But borrowing from the tourist may have cost less interest in this case 0% than otherwise.
Speaker 1:
It is true there's a complication here. The hotel owner gets this 0% loan by embezzling. He didn't actually get the permission of the tourist, but it only took a few minutes for all these debts to be cleared. So, either way, the $100 cash would have been unnecessary if the residents had some sort of central clearinghouse for debt. So it could have been a private bank, some way of a private bank that issued a currency or some kind of script. That's what the money is for, because the problem was a lack of liquidity.
Speaker 1:
Everyone had both $100 asset and $100 liability. What they were lacking was the liquidity in order to clear those things, and the reason the absence of liquidity is a transaction cost. The fact that the hotel owner seems to know that the $100 bill will come back suggests that they had already. They already had everything necessary for this informal clearing. They didn't really need the bill in the first place. What they lacked was information, which, since people didn't have the information that there was this circle of debt which could be closed. That's just transactions cost. That's the expensive information. The hotel owner could have gone to each party in succession offering to take on their debt if he canceled his, so he could have gone through. One person could have gone around as a kind of middleman. We could call that person I don't know a banker.
Speaker 1:
Nonetheless, the example illustrates Ludwig von Mises' point that increases in the efficiency of the clearing system reduce the demand, for that is, increase the velocity of money and what that means. I'll translate that into English, speaking again for myself rather than Professor Hummel. Money often gets clogged up. It's under someone's mattress, someone holds onto it. The velocity of money. The greater the velocity of money, the greater the efficiency of the system. But a lot of times we hold onto it rather than spend it. Probably someone had $100 somewhere in this system, but they were holding it. Getting the chance to grab it off of the hotel counter gave them an outlet, a way of solving this problem of transaction cost.
Speaker 1:
A clearing system is an alternative way of providing the medium of exchange services. So in fact, professor Hummel says he uses a similar example with fewer parties to illustrate the nature and benefits of a clearing system. At the limit, a perfectly efficient clearing system would be an all-encompassing network of computerized barter. It could make money completely unnecessary. So I have a debt. It's denominated in some units. I also have an asset that's denominated in those same units. I can just cancel those if I have an app that allows me to operate within a clearing system. So what the tourist short-term loan did was provide monetary services, the services of clearing and the important thing about that is that it is really just a way of reducing transaction costs. Whoa, that sound means it's time for the twedge. This week's economics joke. And here it is.
Speaker 1:
Before going to Europe on business, a man drove his Rolls Royce to a downtown New York City bank and went in to ask for a loan of $5,000. The loan officer was taken back and requested collateral. Well, what I want to do is leave you the keys to my Rolls Royce, the man said. So the loan officer looked up the wealth of the applicant for the loan. The man was extremely wealthy, and so they were able to offer him a really low interest rate. They signed the papers, had the car driven into the bank's underground parking lot for safekeeping as collateral and they gave him the $5,000.
Speaker 1:
Two weeks later, a man walks back through the bank's door and asked to settle up his loan and get his car back from where it was parked for collateral. The loan officer checked his records and says okay, that's $5,000 in principal and you owe us. Let me see $15.40 in interest for the two weeks. The man wrote out a check, thanked the loan officer and started to walk away after getting his keys. Wait, sir, the loan officer said while you were gone, I did some more investigating and you're actually a billionaire. Why in the world would you want to borrow money? And the man smiled. I didn't really borrow the money. Where else could I securely park my Rolls Royce in Manhattan for two weeks and pay only $15.40? I think that's the worst thing I've ever heard. How marvelous. Now, the reason that I used that joke this week was that it relates to the idea of paying off debts. If we think of money and the paying off of debts as being something that is operating behind a kind of veil no-transcript. Now let's turn to letters. This letter is from MR, an undergraduate student I'm emailing as I have an interesting topic I hope you can cover.
Speaker 1:
For my Intro to Microeconomics class, I had to write a paper explaining a naturalist question in quotes naturalist question. We were required to use a large language model to generate an answer and then correct and explain it in more depth. I chose a question on haggling and why haggling is done in some places but not in others. I found a major reason was differing transaction cost. I asked my professor for a place to start my research. After struggling, he suggested your podcast. I was surprised to find you had not covered this. Well, thank you, mr. That's certainly an interesting question and I'm glad that you were discerning enough to choose a professor who listens to Tidy C. Well done. Now I looked in EconLit, the index of published economics papers, and I only found eight papers on this subject. What I searched for was haggling and transaction cost, and actually only one of those really addressed the question that you ask in any important way. Now I know the answer to your question, but I'm not sure it's very helpful.
Speaker 1:
The cost of haggling is that it raises the price of transacting per unit. So imagine the airport at Atlanta, the line for Starbucks. So you want to get Starbucks coffee Already, the line is 30 or 40 people long. Now imagine that each person has to negotiate the price of their own latte. There's no fixed price. Everybody has to haggle for the price of their latte. Well, the line would still be 30 or 40 people, but it would be two hours instead of 10 minutes. So haggling at scale for inexpensive items makes little sense.
Speaker 1:
What haggling does do is allow price discrimination, which means that the seller can use negotiation costs to discover differences in price elasticity negotiation cost to discover differences in price elasticity. What that means in English is that if you really want something, I can find a way to charge a higher price. I can use haggling. A skilled negotiator can probably get something that's closer to your maximum price. So each buyer has a different maximum price they'd be willing to pay. Haggling allows me to get something closer to the maximum price that the buyer would be willing to pay. Now it's also possible that if the buyer is a skilled negotiator and the seller has a fixed price and they're trying to charge more than that that is, the seller has a fixed reservation price and the seller is trying to get more than that the buyer may be able to drive the seller down to it, so the buyer may not even object. The buyer might prefer, if that person is a skilled negotiator, being able to haggle.
Speaker 1:
The factors are these First transactions cost as a proportion of unit cost? If, like at Starbucks, unit cost. If, like at Starbucks, the cost of negotiating for each latte is a pretty big proportion. In terms of the opportunity cost of both the buyer and the seller, haggling probably doesn't make sense. Second, the labor costs of the seller. How much do I have to pay this worker and how many people are behind them in line? Because if the line is long enough, a lot of people will get out of line and I will lose sales. It doesn't matter if I get a higher price on the relatively fewer things that I'm actually selling.
Speaker 1:
Third, the potential to use price discrimination to increase profits is significant. So we can think of it this way we price lettuce in the grocery store by the head, and early on in the podcast I talked about Joram Barzel talking about the fact that we price lettuce by the head, meat by the pounds and diamonds by the carat. So we have much more expensive measures for things that are relatively more expensive. Here we can add something else. So we price lettuce by the head, we price meat by the pound, but we price automobiles by haggling.
Speaker 1:
Houses are almost always sold by haggling and the reason is that you're trying to discover the price elasticity of the buyer, automobiles in particular. Houses are a little more complicated because every house is different, but I have 30 cars. I could just declare a single price for that, and some sellers claim that they're going to have a no haggle price. But auto sellers keep going back to haggling. So it must be true that they can make more money by doing that, or they think they can. Even though consumers say they prefer a no-haggle price, sellers, automobile sellers continue to use haggling because they can use it to price discriminate, getting a price closer to that particular buyer's maximum reservation price. So it's quite possible that in a country with lower labor costs you would also see a country other than the US. Let's say, in a country with lower labor costs it would make sense to use haggling for meat or for expensive groceries. So there's the answer Transaction cost is a proportion of unit cost, the labor cost of the seller and the potential to use price discrimination to increase profits.
Speaker 1:
Am I missing something, listeners, why is it that we haggle sometimes and not others? You can say that it's cultural, but even in a particular country there's a differentiation. We haggle for some things and not for others. Is there some paper or is there some research that I'm unaware of and was unable to find in EconLit? In any case, mr, thank you for an excellent letter. Well, it's time for Book of the Week. This week's book is by Edmund Phelps my Journeys in Economic Theory, by Columbia University Press. It's a very autobiographical book and actually has a fair amount of actually a surprising amount of political theory, more than I would have expected. There's an entire chapter on the Rawlsian approach to understanding income distribution, which you might not expect from a Nobel Prize winner in economics. So I recommend Edmund Phelps my Journeys in Economic Theory. Well, the next episode will be released on Tuesday, june 11th. We'll have a story on transaction cost. We'll have another book of the week, plus another hilarious twedge and more next week on Tidy C.
