Theorem of Exchange

Preconditions for exchange

1. Exchange occurs when the gains from exchange outweigh transaction costs.
2. Potential gains from exchange exist when people have different marginal use values (MUVs) on
the same good. Thus exchange occurs when the difference between people’s MUVs
outweighs the transaction costs involved in exchange.

The Theorem of Exchange

The Theorem of Exchange states that if private property rights are well-defined and transaction
costs are negligible, when people have different marginal use values on a good, they will
exchange until their marginal use values are equated.
An example:
The following table shows the marginal use value schedules of Mr. A and Mr. B on apples
(number of apples) Q 1 2 3 4 5 6 7 8 9
MUVA 30 27 24 21 18 15 12 9 6
MUVB 24 22 20 18 16 14 12 10 8
Given that there are 9 apples and 1 of them belongs to Mr. A and 8 of them belong to Mr. B. Suppose
transaction costs are zero.
(a) Briefly explain whether Mr. A and Mr. B will trade.
____________________________________________________________________________
____________________________________________________________________________
(b) Who is the seller and who is the buyer? Mr. A is the __________ while Mr. B is the ________.
(c) State the condition for consumer equilibrium.
The consumer equilibrium requires ________________________________.
(d) What is the price of apples? The price of apples is $______.
(e) How many apples each of them owns after exchanged? And how many units will be traded?
After exchange, Mr. A owns _______ apples and Mr. B owns _______ apples.
_______ apples will be traded.

Graphical Approach 1: Adding up individuals’MUV schedules

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 Theorem of Exchange

Graphical Approach 2: Offer Curve

Some Remarks About the Theorem of Exchange

A. The Theorem of Exchange by itself is not directly testable
‘When people have different marginal use values on a good, they will exchange until their marginal
use values (MUVs) are equated.’The quoted statement is NOT directly testable because MUVs is NOT
observable. MUV is the maximum amount one is willing to pay at the margin and willingness is NOT
observable. However, we can derive some refutable / testable implications from the theorem of
exchange in conjunction with other test conditions.

Some Refutable implications:

1. A reassignment of rights will NOT change resource allocation

Refer to the previous example
The following table shows the marginal use value schedules of Mr. A and Mr. B on apples

(number of apples) Q 1 2 3 4 5 6 7 8 9
MUVA 30 27 24 21 18 15 12 9 6
MUVB 24 22 20 18 16 14 12 10 8
Given that there are 9 apples. Now, assume that, before exchange, 1 of them belongs to Mr. A and 8 of
them belong to Mr. B. (i.e. the initial endowment has changed)

Suppose transaction costs are zero.

(a) Who is the seller and who is the buyer? Mr. A is the ________ while Mr. B is the _______.
(b) What is the price of apples? The price of apples is $______.
(c) How many apples each of them owns after exchanged? And how many units will be traded?
After exchange, Mr. A owns _______ apples and Mr. B owns _______ apples.
_______ apples will be traded.
(d) Is there any change in the final resource allocation? _____

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 Theorem of Exchange

2. An increase in the available quantity of a good will lead to a reduction in its market price,
other things being equal.
Refer to the previous example
The following table shows the marginal use value schedules of Mr. A and Mr. B on apples
(number of apples) Q 1 2 3 4 5 6 7 8 9
MUV A 30 27 24 21 18 15 12 9 6
MUV B 24 22 20 18 16 14 12 10 8
Suppose that there is an increase in the available quantity of apples (e.g. there are 14 apples instead
of 9.) Suppose further that Mr. A owns 9 apples and Mr. B owns 5 apples before exchange.
(a) Who is the seller and who is the buyer? Mr. A is the _______ while Mr. B is the _______.
(b) How many apples each of them owns after exchanged?
After exchange, Mr. A owns _______ apples and Mr. B owns _______ apples.
(c) What is the price of apples? Is it higher than or lower than that in the previous example?
The price of apples is $____, which is _______than that in the previous example.

B. Trade is possible between people having identical preference

Even if the preference (i.e. the MUV schedules) of the trading parties are identical, exchange can still
take place when they have different initial endowments. Given that the trading parties have
identical preference, according to the law of diminishing MUV, the one who has more of the good,
his MUV would be lower and he will be the seller. On the other hand, the one who has less of the
good, his MUV would be higher and he will be the buyer. Thus exchange is still possible between
them. Whether exchange take place depends on their MUVs on the last unit, not the shape of their
MUV schedules

C. The distribution of gains depends on the bargaining power and the pricing arrangement
The assumption of price taking is not necessary for efficiency to be attained. Suppose Mr. B is
able to bargain for a price as high as the maximum amount that Mr. A is willing to pay for every unit
of apples. Exchange will still continue until MUVA = MUVB=P (where P is equals to the price of the
last unit of apples traded). However, in this case, all the gains from exchange are captured by Mr. B.
In short, the theorem of exchange has nothing to deal with the distribution of gains, which depends
mainly on the pricing arrangements and the bargaining power of the trading parties.

D. The market price is determined by the equalization of MUVs of all participants in the market,
which in turn equal the market price.
It is the difference in MV, not shortage / surplus, that leads to exchange and determination of
market price . Theorem of exchange states that: If transaction costs are zero and private property
rights are well defined, when people have different MUV on the good, trade is mutually beneficial to
trading parties and exchange will take place. Equilibrium is reached when gains from trade are fully
exhausted at the margin (i.e. P* = MUVA = MUVB =... … = MUVN) Thus, it is the equalization of
MUV’s of all participants in the market, which in turn equal the market price.
Shortage / surplus is irrelevant to determination of market clearing price because the shortage /
surplus is said to exist under given / exogenous controlled price, whereas market clearing price is
endogenous, free to adjust as a result of changes in market conditions.

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 Theorem of Exchange

Exchange with Transaction Cost

With transaction cost (1.5¢),

² the volume of exchange is smaller (X3 - X1 instead of X2 - X1 );
² the gains from exchange is smaller;
² the consumer equilibrium is NOT given by MUVA = MUVB. However, consumer equilibrium is still
efficient because it is impossible to reallocate the good to make one gain without harming others. That
is, the gains from exchange are maximized. Further exchange is not beneficial because the transaction
costs involved outweighs the gains from exchange.

Role of Middlemen and Exchange

Middlemen would earn the price differential between the buying and selling price. The middlemen fee
(0.75¢), which is also a kind of transaction costs. However, the middlemen fee must be lower than the
transaction costs involved without middlemen. It is because if the middlemen fee is higher than the
transaction costs, the trading parties will bypass middlemen and trade among themselves directly.
Middlemen lowers the transaction costs involved in exchange (from 1.5¢ to 0.75¢) leading to
² an increase in the volume of exchange (increase from X3 - X1 to X4 - X1 );
² an increase in the gains from exchange.
In short, ALL (buyers, sellers and middlemen) are benefit from the existence of the middlemen.

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