Imagine you want to buy a cup of coffee on your way to work one morning. You are really craving for a fresh cup of coffee, but there’s obviously a limit to how much you are willing to pay to fulfill your desire. As a consumer, your best case scenario is to get a free cup of coffee. But assuming that free coffee is not available, you would like to pay as little as possible, and not a penny more than $2. This establishes the value of a cup of coffee for you.
On the other hand, a local coffee store owner would like to sell you a cup of coffee, and preferably charge as much as possible. Assuming that it costs $1 to produce a cup of coffee, the coffee store owner would not sell it for anything less than $1.
You go to this coffee store, and find out that a cup of coffee is priced at $1.50. You buy a cup of coffee thinking that it’s a good deal — 50 cents less than what you were willing to pay for it. In a sense, you made a profit of 50 cents in this transaction; 50 cents that you can use somewhere else. The coffee store owner also made a profit of 50 cents. Both parties tried to maximize their own profit, but as a result of this voluntary trade, both benefited.
Now there are other factors — like competition, scarcity, demand — that add complexity, but in its simplicity, this example demonstrates how in a free market, a trade between two parties will take place only when both parties benefit. Suppose there are no other coffee stores nearby, and the coffee store owner starts charging $5 for a cup of coffee. This will distance consumers like you away from them, and create an untapped market of consumers who are looking for cheaper coffee. If there are no artificial barriers to entrance (license requirements, etc.), new coffee stores will open quickly to capitalize on that segment of consumers.
This is a profound, but not widely understood, economic concept: when two parties voluntarily trade with each other in a free market they both benefit. Trade is a positive-sum game. Unlike a zero-sum game, like a robbery, where one party’s loss is other party’s gain, a positive sum game is a win-win for both parties.
A couple of years ago, Egde online magazine posed the following question: “What scientific concept would improve everybody’s cognitive toolkit?”, and Steven Pinker suggested the concept of positive-sum games. Also, check out this illuminating TED talk (linked below) in which Matt Ridley wonders how we became the only species that became more prosperous as we became more populous. And the answer, he argues, is exchange. He gives some interesting examples that demonstrate how exchange (trade) helps elevate living standards.
In the old days, if you were rich, you literally had people working for you. That’s how you got to be rich; you employed them. Louis XIV had a lot of people working for him. They made his silly outfits, and they did his silly hairstyles, or whatever. He had 498 people to prepare his dinner every night. But a modern tourist going around the palace of Versailles and looking at Louis XIV’s pictures, he has 498 people doing his dinner tonight too. They’re in bistros and cafes and restaurants and shops all over Paris, and they’re all ready to serve you at an hour’s notice with an excellent meal that’s probably got higher quality than Louis XIV even had. And that’s what we’ve done, because we’re all working for each other. We’re able to draw upon specialization and exchange to raise each other’s living standards.
Watch the whole thing, it’s quite fabulous.