Content Frame
Skip Breadcrumb Navigation
Home  arrow Student Resources  arrow Additional Readings  arrow Extended-Coverage Topics  arrow Chapter 15  arrow Why We Use Money: The Economics of Barter

Why We Use Money: The Economics of Barter

It is possible for an economy to function without money. When this occurs we are in a barter system. Barter systems were used for thousands of years.

PURE BARTER ECONOMIES

Barter is the direct exchange of goods and services for other goods and services. In pure barter economies, an individual who wishes to obtain goods and services must search for a second individual who is willing to provide those goods and services in exchange for goods and services that the first individual happens to be able to provide. That is, there must be what William Stanley Jevons (1835-1882) called a double coincidence of wants. Two individuals must, by coincidence, own, and desire to trade, matching goods and services.

Suppose that Mr. Blam has just produced ten loaves of bread by working all day. In exchange for eight of those loaves of bread, he wishes to acquire a pair of shoes for his daughter. There may be someone out there--Ms. Delgado--who has a pair of girl’s shoes and who wants bread for her large family. Unless Blam knows about Delgado’s situation, he will have to seek her out, which entails the use of his time. If he fails to do so rather quickly, his bread will become stale. He may decide, therefore, to exchange eight loaves of bread for three pots, even though he has enough pots. Then he might find a trading partner who will take the three pots in exchange for ten pounds of apples. Finally, he might find someone willing to take the ten pounds of apples in exchange for the pair of girl’s shoes. All of this amounts to a complicated, time-consuming, and costly process, to be sure.

This does not mean that barter is always been inefficient. Some societies produce a limited range of goods and services, and only a little trade transpires. In such societies, barter may work well. But when the array of goods and services expands and frequent trading with other societies occurs, the cost of barter will greatly exceed its benefits. A new trading mechanism will gradually replace barter, even though limited barter may continue in a fully developed monetary system. For example, barter still occurs in the United States today (although to a limited extent).

THE SHORTCOMINGS OF A PURE BARTER ECONOMY

A pure barter economy has several shortcomings. Consider the following.

  1. Absence of a method of storing generalized purchasing power: With money, individuals and businesses have a store of generalized purchasing power (as opposed to specific purchasing power in the form of, say, shoes, pots, pans, and so on). Barter provides only a specific store of purchasing power. It allows individuals to store only specific goods, which may decrease in value due to physical deterioration or a change in tastes.

  2. Absence of a common unit of measure and value: Under a barter system, we must express the price of every good or service in terms of every other good and service. Barter therefore leads to the absence of a standardized way to state the prices of commodities. Consider the number of prices that would exist if there were only 1,000 goods in the economy but no money or monetary unit of accounting. People conceivably could exchange each good for the remaining 999 goods. That means that people could exchange shoes for haircuts, symphony orchestra tickets, oranges, milk, or other items. Without a monetary unit, it would be possible to express the price of shoes in terms of the remaining 999 commodities. What is true for shoes would be true for every one of the other 999 commodities. We could determine the number of unique exchange rates, or prices, by the formula

    Exchange rates (prices) = N(N - 1)/2

    where N signifies the number of goods and services exchanged. In the simple example used here, N equals 1,000; therefore:

    Exchange rates (prices) = 1,000(999)/2 = 499,500

    Each time a person in this 1,000-good economy tried to make a purchase, he or she would need to know almost one-half million potential rates of exchange (prices). Switching to a monetary unit of accounting greatly simplifies matters. With one monetary unit of accounting, such as the dollar, the individual in this economy would contend with only N - 1 rates of exchange, or, in this case, 999. Thus, the use of a monetary unit would reduce the number of rates of exchange in this example to one five-hundredths (1/500ths) of what they would be without such a system. Clearly, this reduction in the number of relative prices would make economic life less costly and facilitate trade.

    Typically, the monetary unit used as a unit of account is the same as the medium of exchange. There are exceptions, however. Until relatively recently, in Britain people expressed the values of many commodities in guineas. A guinea was a gold coin worth 21 shillings, but guineas had not circulated for most of the time during which people used that common term of value.

  3. Absence of a designated unit to use in writing contracts requiring future payments: Many contracts deal with future activities and future exchanges. In a barter system, it is difficult to write contracts for future payments in a unit that is readily acceptable to both parties. It is still possible to make such contracts for the future payment of goods or services, but the market value of those agreed-upon goods or services may change drastically by the time the future payment is due.

TRADING-POST ECONOMIES

Because of the shortcomings of pure barter, individuals usually seek to organize exchanges of goods and services. Members of a society accomplish this by establishing trading-post economies, or systems of organized barter. In this type of economy, individuals continue to trade goods and services directly for other goods and services. They organize specific trading arrangements, however, to lessen the problem of double coincidence of wants. A common trading arrangement is the establishment of physical locations, or trading posts, at which people see specific types of goods or services. For instance, people might designate a certain location on a town square for a farmers’ market, while they might set aside another spot as a location for sidewalk sales of clothing and linen goods.

Setting up trading posts provides information to potential buyers of goods about where sellers of specific goods will be located. This benefits the buyers, who save the transaction costs of searching out producers of goods they desire. It also benefits the sellers, who then will not have to carry their goods in search of potential buyers.

Although establishing trading posts reduces the double-coincidence problem arising from barter, it does not eliminate entirely this problem nor the costs it imposes on individuals. While a person knows what will be available at a particular trading post, he or she does not necessarily know what good or service the seller at the trading post would like in exchange.

A way of resolving this problem is for members of society to settle on the widespread acceptance of a single good at all trading posts. This good then is the medium of exchange, or money good. In an organized trading-post system, it is a relatively simple matter to make this step. Once it is taken the economy has made the switch from barter to money.




Pearson Copyright © 1995 - 2010 Pearson Education . All rights reserved.
Legal Notice | Privacy Policy | Permissions

Return to the Top of this Page