One solution to the Gift Economy Puzzle

Courtesy of Iomedae

The usual mechanism for trade is advance agreement on what A gives B in exchange for what B gives A. The gift exchange alternative is that B gives A something and then A gives B something he thinks appropriate. Why would it ever make sense to do it that way? In my previous post I described a gift economy as something I understood emotionally, as a participant, but did not understand as an economist. I think I now have at least part of an answer.

Suppose what I am selling you is information. It is hard to tell you enough about it to let you judge its value without giving away part or all of what I am trying to sell. Instead I tell you the information and you pay me what you think is the price you would have agreed to pay if you had known what you were buying but valued it as if you didn’t.

This only works if I can trust you. I might do so because I know you are honest. I might be a repeat player, expect to come up with information of value to you in the future, information I will pass on to you if and only you have demonstrated a willingness to pay me what it is worth. It might be that other people will have information for you in the future, people who know me and will decide whether to trust you on the basis of our interaction.

Another example, the same logic for a different reason, is tipping; I can’t bargain how much I will tip for good service in advance because I only know how good the service is after it is delivered. Even if I am not a regular customer I have reputational reasons to keep the implicit contract, reputation not with the waiter but with my fellow diners.

Suppose I occasionally engage in transactions for which a gift exchange could work better and in others where there are no special problems preventing an ordinary bargained sale. Gift exchange still works for those transactions, provided I can trust you. By choosing to use it I give you an opportunity to demonstrate that you pay fair value for what you get which will be valuable to both of us in future transactions that do raise such problems.

There are two disadvantages to gift exchange as a substitute for sale. One is that it depends on trust. The other is that it provides no way of knowing if the transaction should take place at all. If the higher price you are willing to offer for my goods is less than the lowest price I am willing to accept you don’t buy them and shouldn’t. If I give you the goods I only discover that I shouldn’t have when I find out how much you are giving in exchange.

Discovering Something I Already Knew

That explanation for gift exchange did not occur to me a few days ago when I was writing a post on the subject but it should have since I had seen it, indeed quoted it, in an earlier post:

I really do not want people to be worse off by their own lights because they did not, before telling me a lot of information about the future which I valued highly, think to ask for my agreement not to invade any countries on the strength of that information, an assurance I would've given if you'd asked for it. If it's predictably a bad idea to tell me things - well, in the ultimate accounting it's still just a price to pay if it's worth it, but it's not a price you can pay selectively, and I don't think it's in fact a price worth paying."

…

Being an entity whose decision procedure doesn't make people regret telling me true information without carefully prenegotiating, and grants them the conditions they could've prenegotiated including the conditions they could've prenegotiated if they understood how to negotiate with Lawful gods, seems easily worth millions, probably billions, of lives in expectation. (Iomedae in a Glowfic thread by Lintamande)

Gift Exchange and Firm Size

In “The Nature of the Firm" Ronald Coase described two alternative mechanisms for coordinating economic activity and offered the tradeoff between the two as an explanation for the existence and size of firms. One mechanism is market exchange — if you need something you buy it. The other is hierarchy — you employ people and tell them what to do. Firms and individuals interact by trade but the firm itself is a miniature command economy. As I put it in  Hidden Order:

 The capitalist system of coordination by trade seems to be largely populated by indigestible lumps of socialism called corporations.

Both mechanisms have costs. A command economy faces the problem of internal coordination without market signals or market incentives. Coordination by trade faces the problem of transaction costs. A firm expands the range of what it does in-house, coordinated by hierarchy, command, up to the point where the inefficiency of doing more things that way is large enough to balance the costs of doing them on the market, outsourcing. That, Coase argues, is what determines the equilibrium size of firms.

Gift exchange is a form of trade that, for some transactions, reduces transaction costs. It should, at least in high trust societies, reduce the equilibrium size of firms in industries where such transactions are common.