Wampum, Trading Posts, and Barter

"Arguing in My Spare Time" No. 2.14

by Arnold Kling

May not be redistributed commercially without the author's permission.
Index

Quiz: from which well-known doomsday scenario might the following description be taken?

"As conventional markets and monetary systems collapsed, people reverted to primitive forms of exchange. A variety of tokens came to be used as money. Prices were set at trading posts where people gathered to haggle and bid for goods and services. There was speculation about the likelihood of a return to barter."

If this sounds to you like a breakdown caused by the Y2K computer problem, that is a reasonable guess. However, in fact the doomsday to which the quiz refers springs from the imagination of pundits and venture capitalists. The frightening scenario is:

e-commerce

Of course, the history of economic institutions includes wampum, trading posts and barter. However, these were superceded by the invention of modern money and commerce. The advent of the Internet may change the cost-benefit calculus for commercial institutions. However, in this essay I wish to temper the enthusiasm for the return to ancient mercantile processes.

First, let me make the case against barter. The economic textbook argument is that sometimes the butcher wants candlesticks, but the candlestick-maker wants shoes. Meanwhile, the cobbler wants meat. If only barter is available, it takes considerably more co-ordination to effect transactions. The process could be simplified if everyone accepted currency in exchange for the goods that he or she sells. Furthermore, in an economy with n goods, economic agents must keep track of an n by n matrix of relative prices if barter is the means of exchange.

With computers and the Internet, the cost of multilateral transactions falls. This could make barter less expensive than it otherwise might be. However, it seems unlikely that those costs would fall sufficiently to make barter as efficient as money. In fact, although barter has been discussed in such avant-garde forums as www.netpreneur.org and www.edge.org, and even though there is a site called barter.com, there does not appear to be any major buzz around the idea of barter at this time.

The other primitive institutions have considerable capital and hype behind them. The trading post idea is embodied in the auction frenzy, represented most notably by eBay.com. Auctions also are being tried at amazon.com and Dell, among many others. Some pundits have written that in the future every price will be determined at an auction.

The alternative to a trading post is a dealer. A dealer carries an inventory and posts a price that is fixed, at least for a period of time. As a consumer, if you want a product that the dealer sells, your expectation is that whenever you want to purchase the product you can do so at the dealer’s price.

At a trading post in which prices are set by auctions, you cannot be sure that the product that you want will be available. Also, you have to go through the auction process to determine the price at which you may obtain the product. The consumer takes more price risk. Presumably, prices are lower on average, because the trading post does not maintain inventory, and sellers can unload their inventory with certainty at the time of an auction.

Whether I prefer to shop at a dealer or at a trading post depends on how my time sensitivity compares with my price sensitivity. If I want an aspirin for a headache, I would rather go to a dealer than to a trading post. I need the aspirin now, and I do not want to take the risk of having to pay a very high price. On the other hand, if I am buying wine for my cellar, I might prefer an auction.

The Internet lowers the cost of setting up trading posts, because it lowers the cost of assembling a critical mass of buyers and sellers. However, by the same token the Internet lowers the costs of operating as a dealer. By having a warehouse-and-shipping operation instead of a collection of stores, a dealer is able to reduce inventory costs considerably. Overall, it is not clear that the Internet should promote trading posts rather than dealers.

Economic theory assumes that uncertainty about price and availability is a "bad." We presume that people prefer certainty to risk. However, uncertainty also can be fun. The consumer taste for gambling and frequent stock trading reflects this non-economic reward. Thus far, my guess is that the popularity of auctions owes more to this taste for uncertainty than to any shift in costs that favors trading posts over dealers. Assuming that for most people this taste for uncertainty is limited, my guess is that those who are predicting a massive shift toward auctions are overbidding their hands, so to speak.

Another phenomenon that has drawn capital and hype is alternative currencies, or wampum. These are generic non-monetary incentive systems. Examples include mypoints.com and cybergold.com. They attempt to create a customer loyalty reward system that allows the consumer a broad choice of rewards. As such, they are very nearly oxymoronic.

The classic customer loyalty system is frequent flyer miles. Because the airline industry has declining marginal costs, an airline wants to lower your marginal cost of flying without cutting the price of an airline ticket. Frequent flyer miles are the answer.

Frequent flyer miles turned out to be a promotional coup for airlines. Because of the units involved, people who are fond of big numbers get very excited by awards of 500 or 1000 miles, even though the monetary value of such a reward may be less than a dollar. This phenomenon might be called number illusion. Thanks to number illusion, frequent flyer miles have become so popular with consumers that other industries, such as hotels, have been induced to participate in airline frequent flyer programs. Thus, the airlines have been able to earn seignorage, which is the profit that goes to the provider of a currency (typically a government).

The concepts of mypoints.com and cybergold.com retain the number-illusion and seignorage aspects of frequently flyer miles. However, they dilute the customer loyalty aspect. If I can earn points at site x and spend them at site y, then site x does not benefit by issuing points.

The fact that frequent flyer miles achieved widespread acceptance as an alternative currency is quite interesting. My guess, however, is that it is truly an exceptional case to study. I suspect that the number of alternative currencies that people are willing to hold is limited. Indeed, to the extent that cybergold or mypoints address any market need, it is that consumers do not want to hold wallets filled with many different brands of wampum.

With the exception of frequent flyer miles, consumers do not value brand-specific wampum very highly. Generic wampum fails to provide the customer loyalty benefits that are the reason for companies to issue wampum. Therefore, I would not bet a whole lot of money (or frequent flyer miles) on the Internet leading to spectacular growth of wampum.

I believe that the Internet can change economic processes in fundamental ways. Consider the three functions of marketing (persuading the consumer to buy the product), sales (actually processing a sale), and distribution (putting the product in the consumer’s hands). Before the Internet, it made sense to put sales and distribution in the same location—a physical store. However, marketing was separate (advertising on newspapers and television, not in the store). With the Internet, it makes sense to combine marketing and sales on the same web site. Distribution becomes separate from sales, because you cannot hand the product to the consumer on the Web site (unless it is a downloadable product).

With the Internet, the cost of all three processes can be reduced. The cost of marketing can be reduced, because it is less expensive to provide information over the Internet than over traditional mass media. The cost of sales can be reduced, because the sales process can be centralized and automated. The cost of distribution can be reduced, because inventory can be centralized and reduced.

These cost reductions can be achieved without reverting to wampum, trading posts, and barter. And genuine cost reductions will not require hype or investor exuberance to sustain their viability.