The Riddle is Transaction Costs: That's What the Money is For!

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.

Links:

• David Henderson gives a statement of "the riddle"
• J.R. Hummel's web site
• Similar story, from LvMI

Haggling:

Sebastian Schweighofer-Kodritsch, "The Bargaining Trap," Games and Economic Behavior, November 2022, v. 136, pp. 249-54.

Book recommendation:

• Edmund Phelps, My Journeys in Economic Theory.  Columbia University Press.  https://cup.columbia.edu/book/my-journeys-in-economic-theory/9780231207300 

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 

Transcript

Riddle of Debt and Transaction Costs

Speaker 1 0:00

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 1:00

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 2:22

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 3:09

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 4:28

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 5:20

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 5:53

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 6:47

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 7:34

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 8:35

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 9:13

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 .

Haggling and Transaction Cost

Speaker 1 10:49

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 11:58

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 12:34

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 13:34

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 14:14

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 14:52

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 16:04

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 .